Lights, Camera, Action!
Investment professionals appear to have all the advantages. Their days are amateurs' nights and weekends. They are assisted by research teams, whether directly, in the form of analysts who serve portfolio managers and consultants, or indirectly, in the form of home-office support for financial advisors. Often, they have access to private-placement or institutionally priced investments that are not available to retail buyers.
Unfortunately, they also have customers. And customers expect action. What's the point of doing all that work if it doesn't lead to decisions? Switching from commission-based compensation to an account-based amount, or a flat annual fee, doesn't eliminate that question. If anything, it strengthens it. I paid you all year … for nothing?
This week, Reuters unintentionally demonstrated this drawback for professional investors--and edge for retail buyers--in "Special Report: Fidelity puts 6 million savers on risky path in retirement." The article's main points:
1) Fidelity's target-date funds, the Freedom series, have suffered net redemptions, while its competitors have enjoyed inflows.
2) One of the main reasons that investors are leaving is because they are uncomfortable with the series' relatively high risk.
Well, yes and no--with the "no" part supporting this column's thesis.
First, some background. Fidelity didn't invent target-date funds; that honor went to the same firm that created the first index fund, Wells Fargo/Barclays Global Investors. Fidelity wasn't far behind, though, launching the Fidelity Freedom series in 1996, making it the second overall retirement-plan provider, and the first major player, to offer target-date funds.
Birthdays being easier to determine than whether one is a conservative, moderate, or aggressive investor, target-date funds quickly supplanted the existing breed of "customized" balanced funds, thereby forcing every 401(k) provider to respond. Before long, there were dozens of target-date series. The consultants and advisors who served plan sponsors began to study those series carefully, steering those customers to the best of the breed.
That was not Fidelity, which was outflanked by its two largest competitors. Vanguard deeply undercut Fidelity's pricing, while T. Rowe Price opted to hold more stocks. Both challenges succeeded. Fidelity's actively managed stock funds struggled, which permitted Vanguard to sustain its cost advantage. Meanwhile, the strong stock market (aside from the major exception of 2008) aided T. Rowe Price.
Under the Microscope
Which brings us to the main point. Retirement-plan services being a mature industry, and consultants and advisors being paid to do something, Fidelity's Freedom funds began to attract inordinate attention. There wasn't much between this provider and that provider. Those who served plan sponsors were eager to tell a story that seemed important. The weakness of the Fidelity Freedom series stood out.
The criticism began to cost Fidelity assets--and led to its proclamation in 2013 that it would adjust the series' strategy. ("New great taste!") Predictably, that announcement only accelerated the problem. Those who sold against Fidelity seized upon that statement as proof of weakness. Fund companies that change their strategies midstream, they said, are those that have lost their way.
Specifically, the claim became that the Fidelity Freedom funds had become too aggressive. The company had pushed up the funds' stock weightings; permitted more tactical allocation; and increased their stake in noncore assets, such as emerging-markets equities and high-yield bonds. Owning the Fidelity Freedom funds was imprudent.
The series' largest outflows came the year after the strategy change, in 2014. Since then, they have gradually slowed, to the point where Fidelity's overall target-date flows were positive last year. Freedom remained negative, although only very slightly, but the company grew its other retail target-date series (which uses only index funds) and its stable of target-date separate accounts, which clone the retail funds while carrying lower expense ratios.
Thus, while the Reuters story argues that investors are leaving the Freedom series because they dislike its risk, the evidence indicates the opposite. Plan sponsors--not investors, as 401(k) participants purchase the funds that are put in front them--left the series because its track record was mediocre, because the consultants and advisors who serve the sponsors counseled them to do so, and because Fidelity's strategy change left them uneasy. Now, they are growing more comfortable. They are returning to Freedom.
They return because the performance has been strong. Over the trailing five years, the Fidelity Freedom funds have outgained 85% to 90% of the competition (the results vary by the target date). Once again, the professional investors chased their tails. By the time that they expressed serious concern about the Freedom funds, the bad news had already been experienced. Once they took action, the good news ensued.
It is true that the Freedom funds have greater volatility than most. However, neither their equity positions nor their standard deviations are significantly different than those of the T. Rowe Price target-date funds, and there are smaller target-series that are higher yet. My take: This talk is a vestige of what was. This is how the consultants and advisors spoke of the Freedom series back in the day. It remains the way that detractors think about those funds. But the power of that criticism is waning.
This is the true story, as I see it. Investment professionals devoted too much attention to the Fidelity Freedom target-date funds because … they were professionals. Their clients expected them to give reports and to make recommendations, so that is what the professionals did. To the extent that they affected the Freedom funds' asset flows, they hurt 401(k) participants' returns. The biggest outflows came just before the funds enjoyed their highest relative performance.
In the grand scheme of fund investing, this is not a tragic tale. Freedom's outflows were modest, as a percentage of the series' total assets, as was its funds' subsequent superiority (large victory margins being rare in the target-date categories). Nonetheless, it serves as a reminder that sometimes it is best not to be paid for one's thoughts.
Final Note: Morningstar's Jeff Holt, who assisted with the background for this story, responded after reading this column's draft. "Interestingly, the outflows undoubtedly caused Fidelity to revisit its target-date offerings, ultimately resulting in an improved strategy for current investors."
Good point, Jeff. I could have entitled the column, "How Professional Investors Help Fund Companies--If Not Always Their Own Clients." Perhaps another time. There are always columns to be written!
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.