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Is Your Target-Date Fund Quality to the Core?

Some series contain less-desirable offerings.

Morningstar Analysts, 09/21/2009

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

Target-date funds are complex investments. The funds' asset-allocation shifts as an investor nears retirement, following what's known in the fund industry as a "glide path." Picking a fund with a glide path that fits one's tolerance for risk and retirement savings habits is tricky enough, but investors also need to weigh the structure and quality of the target-date funds' underlying holdings.

As Morningstar noted in its target-date industry survey, which was released last week along with 20 new Morningstar Target-Date Series Ratings and Reports, there are many complexities and nuances to the ways that target-date firms adapt their asset-allocation choices to actual portfolio allocations. As with glide paths, there are several possible--and potentially appropriate--approaches that target-date fund series may take, and investors should look closely to see if the approach of a given target-date series fits with their own investment preferences.

Fund of Funds or into the Pool?
One thing to consider is whether a target-date series uses a fund of funds structure. The roots of the industry lie in that direction, as the Big Three of Fidelity, Vanguard, and T. Rowe Price, which represent more than 70% of industry assets, each populate their target-date funds with existing single-strategy mutual funds. For the most part, the fund of funds model has been adopted by later entrants as well, although often the newer players have lacked a full stable of appropriate in-house funds from which to select.

Recently, however, some fund families have experimented by doing away with the fund of funds structure and instead hold securities directly through a master pooling arrangement. Using a master pool frees the target-date funds from paying the stated fees charged by the underlying funds--and thus potentially passes on its cost savings to investors. On the other hand, it can be tricky to implement such a structure when using a number of active managers. It can also be more difficult for investors and fiduciaries to judge the strengths and weaknesses of the underlying managers when a master pooling structure is in place.

Going the Active or Passive Route?
A more significant question is whether a target-date series uses active or passive management to run the underlying portfolios. On that front, the target-date industry remains strongly committed to active management. There are more target-date fund series that have essentially 100% of their assets invested in actively run funds than there are series that have even a moderate stake in passively run assets. However, the current investment popularity of indexing strategies, along with the political pressure to include more indexed options within 401(k) plans, appears to be having an effect. Recently TIAA-CREF and Fidelity--two firms with existing, actively managed target-date funds--announced plans to offer fully indexed target-date series. In addition, some firms, including John Hancock and Schwab, have mixed in substantial proportions of index vehicles alongside actively managed funds.

In-House Talent or Guns for Hire?
Another distinction we've found is whether a target-date firm chooses to run the assets in-house, or to use external subadvisors. Because target-date funds invest across a range of asset classes (some fairly specialized, such as commodities, global real estate, high-yield bonds or preferred securities) it is questionable whether any fund family truly possesses the expertise, experience, and resources necessary to invest each of those asset classes effectively over the long haul.

Current industry practices are quite varied. Several major fund families use all in-house funds, such as Vanguard, T. Rowe Price, Putnam, Fidelity, and American Funds. In contrast, Vantagepoint (whose funds are available only to public-sector employees) uses only third-party subadvisors, and John Hancock and Principal opt for a combination of in-house management teams and external subadvisors. It's logical to think that a company lacking expertise in managing a particular asset class should seek a stronger subadvisor to manage that slice of the target-date portfolio. Yet evaluating and monitoring subadvisors also requires specialized expertise and experience. The manager selection teams and processes at some target-date companies are significantly more advanced than at others.

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