Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The target-date fund categories have been a rare bright spot within the mutual fund industry. Joining me to share the latest research on these categories is Josh Charlson. He is senior fund analyst with Morningstar.
Josh, thank you so, much for being here.
Josh Charlson: Hi, Christine, great to be here.
Benz: Josh, I think at this point most investors are familiar with the concept of target-date funds. They attempt to give you an age-appropriate asset-allocation mix and then gradually make it more conservative as the years go by. We've seen a really strong uptake in terms of asset flows into these categories. Let's talk about the magnitude of those flows.
Charlson: Target-date funds have continued to do really well in the fund industry. They've been one of the few areas to experience constant growth. They've tended to outgrow other broad asset classes in the fund universe. Last year, they took in net inflows of about $55 billion, growth of about 15%. There are a couple of reasons for it. One is going back to 2006, the Pension Protection Act, which made them qualified default investment alternatives in retirement plans, so people can be put into them immediately.
Benz: If you do nothing [in a company retirement plan], you might get opted into [a target-date fund].
Charlson: Right, such as if you're starting with a company [and participating in the 401(k) plan] or if they're switching their plan. And a lot of people just like them for their simplicity and ease-of-use. We think they're among the most easy-to-own types of mutual funds.
Benz: You and the team have been rating these funds for the past three years. You looked back on how those ratings have done in terms of predicting performance. And of course it's very early days, but when you look at those funds that you had given the top ratings back in September 2009, how did they do in the subsequent three years?
Charlson: We've been pleased with what we've found, and as you said, it's an initial study. We covered 20 target-date series initially, and there tend to have been 40 to 50 per year in the categories. We found that [funds that had] Above Average and Top ratings continue to outperform their peers at a high rate and tended to outperform the peer-group average at a nice clip, whereas lower-rated funds, the Below Average and Bottom, tended to do much more poorly. So, we're pleased to see there's some level of predictability there.
Benz: Right. One thing I noticed, Josh, was that the ones that were sort of middle-rated, they also did reasonably well.
Charlson: They did do well, and we're happy to see that, too. Funds that have been rated Average, or Neutral under [the Morningstar Analyst Rating] system, those are funds that have good qualities, too. We don't think that they'll do poorly for investors. Usually there are one or two areas that are a little more deficient. It often has to do with our impression of the parent company. So they may perform well, but we may have concerns about the longer-term stewardship of the parents in those cases.
Benz: So you and the team recently made some adjustments to the ratings methodology that it sounds like their bottom-line goal was to bring those ratings more in line with what we're doing for individual mutual funds. Let's talk about what's gone on there.
Charlson: We've mapped them over to what we're now doing for individual funds with our medal system, Gold, Silver, Bronze, et cetera, and in doing so we made some changes to the underlying methodology, the way we rate certain pillars. So, it wasn't just a simple mapping. We sort of rerated each element, and there are some differences between how we look at target-date series versus how we look at an individual fund.
Benz: One thing you noted in your research report was that there's been a change in how you look at process. So, there's a qualitative element and a quantitative element. I'd like to hear about how you and the team, when you're looking at specifically asset-allocation methodology, how do you qualitatively rate that, and what sorts of things are you looking at.
Charlson: It is definitely a little bit of a challenge, and that's one of the reasons why initially when we started our target-date coverage, we didn't even rate the process part of it, we wanted to sort of get our hands around it. So, there are some things we look for. We want to look for consistency of process and philosophy. We want to see a philosophy that is articulated well and then is matched in the implementation. Are they doing what they say they do in theory in terms of how they design the glide path, how they select the asset classes in the funds? Do they have resources to match the type of work that they do? If they do a tactical allocation type of process, do they have the people to do it? Do they have the history for it? And when they make changes are they made thoughtfully, or is there more of a marketing or gimmicky angle to it?
Benz: Or performance-chasing angles?
Charlson: Or performance-chasing, as well, yes.
Benz: So Josh, when you look at the series--the top ratings, the Gold ratings currently--Vanguard and T. Rowe Price are at the top of the list. Let's talk about what you think those groups are doing right in terms of their target-date lineups.
Charlson: Sure, and those are two target-date series that we have liked for quite a while. They both approach it somewhat differently. There's no one single way to get to a top rating. Vanguard is index-based, and very low-cost. The fees have always been a big advantage for them. They're experts in indexing and have very low tracking error. And they're thoughtful about their asset allocation. They made a change about a year ago, I think, raising their international allocation from 20% to 30%. They put some research into it. They put some good communications out about it.
T. Rowe Price on the other hand is mostly actively managed, though they do use some indexes. For an active manager, their prices are good. Their underlying funds are very strong. Even though they have one of the more aggressive glide paths or asset allocations, their funds have sort of made up for performance during down markets. They do quite well versus expectations and, again, on an asset-allocation perspective, they are very consistent and very thoughtful, with a lot of resources put there.
Benz: Then on the next rung, in terms of the rating system, the Silver-rated series, you've got American Funds, Manning & Napier, JPMorgan and MFS. That's obviously a broad basket, but let's talk about some of the highlights within that Silver band.
Charlson: It's kind of an eclectic group. They run their series somewhat differently. American Funds has some of the strongest underlying equity funds. MFS is a series that we've liked, but it's been hurt by its fees in the past. We made a change to our price methodology that sort of makes it a little fairer for firms that distribute to smaller plan which can have some broker charges on that; they look better under that system. They've got a nice asset-allocation process. Manning & Napier tends to have a more active process but their underlying funds have a long track record, very strong. And JPMorgan is very diversified and has very good asset allocation. They have a tactical process that's added value. We like the manager, Anne Lester, a lot.
Benz: Now, I guess a follow-up question for you, Josh, is if someone is looking at their employer's lineup, and they have a target-date provider who's not one of these top-rated providers, how should they think about whether to employ the target-date fund in their plan or whether to maybe cobble together their own choices?
Charlson: I would say anything that we rate Neutral or higher is something that we'd be very comfortable with an investor using, as I mentioned before. Neutral funds can perform well. They just have an area or two, usually that has something that's a little weaker, but we expect them to perform at least at the market level or the peer level. If something is rated Negative, we would recommend looking for other options, seeing if you can put together a similar asset-allocation program through index funds or the like.
Benz: Josh, Thank you so much, great research. We appreciate you sharing it with us.
Charlson: Thank you, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.