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Surveys, Target Dates, and More

A roundup of investment news.

Morningstar Analysts, 10/06/2009

RIAs Prefer ETFs, Mutual Funds, Survey Says
As broker/dealers move to increase fee-based advice relationships, the business models of B/D-affiliated advisors might seem to be converging with those of independent registered investment advisors. But as a recent Morningstar Advisor/Cerulli Associates survey of advisors shows, significant differences in the channels remain, most notably in product allocation and client net worth.

The survey reveals that RIAs have a higher percentage of their assets under management (56%) invested in traditional 1940 Act mutual funds than those advisors affiliated with a broker/dealer (49%). The difference is attributable to RIAs' higher allocation to equity mutual funds, which account for 38% of RIA assets compared with 30% of a typical B/D respondent's assets. To complement their fund usage, RIAs have also adopted ETFs, which account for 9% of RIA assets but only 2% of B/D advisor assets. The survey also found that B/D advisors are more likely to allocate assets to insured products: 19% of B/D advisors' AUM are attributed to annuities and life insurance products versus only 4% among RIAs.

The survey also shows that RIAs have been able to target and acquire clients in higher net-worth tiers more successfully than their B/D counterparts. Only 49% of RIAs focus their practices on clients with less than $1 million in net worth, but these core markets account for 71% of B/D advisors. Although this finding would seem to indicate that advisors wanting high-net-worth clients should go the independent route, it is more about correlation than causation. Those advisors who have transitioned to the RIA channel have been more likely to be working with high-net-worth clients before their move than the average advisor. In these cases, advisors' migration to the RIA channel was more a validation of their success than a catalyst for it. The size of populations also come into play: There are about nine times as many B/D advisors (276,000) as RIAs (33,000), so the population of high-net-worth investors being served through traditional B/D channels outnumbers those served by RIAs.

In the same survey, we wanted to find out what is attracting advisors to ETFs, and we weren't surprised that it's cheap expenses. Just more than half of survey respondents cited low fees as an important factor in influencing ETF usage. Cerulli has generally seen greater adoption of passive products and greater cost sensitivity among independent RIAs than in traditional B/D channels, and this was evident in the survey: 63% of RIAs named low fees as a major factor in their adoption of ETFs compared with 44% of B/D advisors.

Advisors also see ETFs as an efficient way to gain exposure to specific investment themes. Nearly two thirds of survey respondents use ETFs to gain equity exposure, and nearly half of survey respondents reported that they largely use ETFs tactically and actively trade them.

ETF usage was fairly widespread among respondents, but penetration is not as deep across the broader advisor universe, with only about half of all advisors having used ETFs. Half of all survey respondents plan to increase ETF usage in the coming years--with almost no advisors planning to decrease their usage. (View the related graphic here.)

This report was prepared by Bing Waldert, a director with Cerulli Associates, and Scott Smith, a senior analyst with Cerulli Associates. 

Costs of Target-Date Funds Vary Widely
An analysis of target-date fund expenses reveals a dramatic range of fees among the 34 series that were studied (at least an 18-month history was required), says Josh Charlson, a Morningstar analyst who performed the study.

"The difference between the cheapest and most expensive target-date series amounted to more than 120 basis points annually, an eye-opening disparity," Charlson says.

Sorting out target-date fund expenses can be tricky, in part because there are so many share classes, often aimed at different-sized retirement plans. Using the net prospectus expense ratio, Charlson selected the lowest-cost share class from each series that holds at least 10% of total series assets to ensure a meaningful investor presence in that share class. Then, he averaged the expense ratio for the share class across all the funds in the lineup to get an overall average for the series.

The cheapest funds by far, Charlson says, belong to the Vanguard Target Retirement Series, with an overall expense ratio of 0.19%. The Vanguard target-date funds, built on a foundation of its extremely low-cost index funds, are much less expensive than even the next closest index funds from Nationwide (0.65%) and Wells Fargo (0.67%), whose fund expenses do rank favorably compared with the target-date universe as a whole.

Among actively managed offerings, American Century Livestrong is the cheapest option, with a 0.67% expense ratio, on par with the indexed series from Wells Fargo. Bunched closely behind are TIAA-CREF Lifecycle, T. Rowe Price Retirement, and Fidelity Freedom. With the exception of TIAA-CREF, all these fund families have eliminated the so-called overlay fee, a management fee that sits over the fees on the underlying funds, common among target-date funds. Other firms, such Schwab and John Hancock, mix index funds with active strategies in order to achieve some cost efficiencies.

The priciest target-date offerings are run by advisor-sold Franklin Templeton (1.27%) and Oppenheimer (1.44%). "The cost structures may be inherently higher at firms like these that sell into the smaller-plan market through advisors," Charlson says, "but the broker-sold American Funds series charges just 0.71% for its A shares, so clearly there are ways to shave costs within this distribution channel.

"A little digging around could yield big savings over the long-haul investment horizon of these funds," Charlson says. (View the related graphic here.)

Lackluster Results for Active Management
If you compare the returns of the Morningstar Style Indexes with active funds in the relevant style categories, fund managers are having a difficult time, says Travis Pascavis, Morningstar's director of equity indexes.

Pascavis based his views on the percentage of active managers that had a return at the end of the period in excess of their respective Morningstar style index. The study included 2,200 funds in the one-year period ending June 30, 2009, and 2,197 funds in the five-year period, including all funds that existed at the beginning of the study.

Four out of nine style categories had more than 50% of the funds winning over the past 12 months.

Over a longer period, the odds of an active fund beating an index diminish. Over five years, the style indexes beat more than half of the funds in all but two categories. In fact, only 17% of the active funds in the large-growth category exceeded the Morningstar Large Growth Index in that period. Large-growth funds had the best five-year record, and part of these funds' success was owed to their portfolios shifting toward mid-growth, Pascavis says. (View the related graphic here.)

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