Morningstar's John Rekenthaler lays out our prescription to make these funds--which can serve an important role for many investors--more shareholder friendly.
Over the past several months, target-date mutual funds have been increasingly scrutinized for their losses, raising questions about the transparency and suitability of these ostensibly safe investments. Morningstar's vice president of research John Rekenthaler testified Wednesday before the Senate Special Committee on Aging about this issue. The text of his testimony is below.
My name is John Rekenthaler. I am vice president of research for Morningstar. Thank you for inviting me to speak today before the Senate Committee on Aging.
Morningstar is a leading provider of independent investment research and the largest provider of mutual fund research in the United States. Recently, Morningstar published a detailed report on target-date mutual funds, creatively titled Target-Date Series Research Paper: 2009 Industry Survey. My presentation today contains key findings from that report.
I would like to state upfront that Morningstar is generally supportive of target-date funds. Throughout its history, Morningstar has frequently criticized entire categories of funds for being gimmicky and/or overpriced. We are considerably more positive about target-date funds. We regard target-date funds as being a sound invention that meets a true investor need. By offering broadly diversified portfolios that change over time, target-date funds are a suitable choice for those who wish to delegate their investment decisions. They also are well suited for inactive owners who will not be making trades as they grow older and their situations change.
That said, there are certain concerns, given the extraordinary position that target-date funds now occupy as the default investment of choice for America's New Retirement Model. These concerns include:
The first concern lies with fees. Overall, annual expense ratios for target-date mutual funds compare favorably with the expense ratios charged by other types of mutual funds. For example, on an asset-weighted basis, that is with the larger funds counting proportionately more in the calculation than the smaller funds, target-date funds have an average annual expense ratio of 0.69%. This is lower than the 0.82% figure for so-called "allocation" funds, which also invest in a broad mix of stocks and bonds.
However, the average conceals a very wide range among the 48 target-date fund families that we track. On the low end, one target-date family has an expense ratio of only 0.19%. On the high end, another has an expense ratio of 1.82%--more than 9 times higher than the first family. The issue of expenses is particularly important with target-date funds because of their very long time horizons. Several fund families today offer funds with a 2055 date--46 years into the future! As the Committee well knows, the power of compounding greatly magnifies small differences over such a long time period.
For example, let's assume two target-date funds that invest in identical underlying assets, returning 7% annually. One fund boasts the industry's low expense ratio of 0.19% and the other has the industry's high expense ratio of 1.82%. Over the 46-year time period mentioned above, an initial investment made in the low-expense fund would become worth more than twice as much as the investment that was made in the high-expense fund. (A lump-sum investment of $1,000 in the two funds would grow to $20,708 and $10,208, respectively.) Few employees who are defaulted into target-date funds through their 401(k) plans will be aware of the expense differences that exist among funds, and fewer still will understand their very powerful effects.