American Funds Target Retirement Delivers, on Its Own Terms

American Funds’ target-date series is proving investors still have an appetite for actively managed strategies, and it’s doing it the old-fashioned way: with below-average fees and long-term performance that leaves most peers far behind. But as some of the favorable market conditions that boosted its results start to reverse, can it keep up?

American Funds has been the only target-date provider of its kind in the top five target-date flow-getters in the past four years, an all-active manager bucking the trend of low-cost index-based series storming the charts. 2020 was another blockbuster year for the series, raking in $13.5 billion in inflows while the overall target-date market was in net outflows. For the last decade there's been a seismic shift in money flowing away from actively managed funds and toward cheap passive alternatives. Target-date funds have been no exception to that trend and in 2020, despite flows turning negative for the first time, share classes in the cheapest quintile continued to see positive inflows, as shown in Exhibit 1.

Exhibit 1: 2020 Net Flows

- source: Morningstar Direct as of Dec. 31, 2020.

Plan sponsors that choose target-date funds for defined-contribution plans have grown increasingly fee-conscious, and with good reason. Lawyers representing wide swaths of plan participants filed nearly 100 excessive fee lawsuits against 401(k) plans in 2020, up from 19 in 2019, reported mutual fund industry news site Ignites.

This trend leaves most target-date series that use all actively managed funds without much chance to compete. American Funds has been the lone exception among mutual fund series, and is the only series to collect more than $1 billion in net inflows for 2020 that uses all actively managed funds. Exhibit 2 shows the top 10 series ranked by net inflows for the year.

One edge American Funds does have versus other active-based series is that it’s the cheapest of the bunch. Its 0.39% expense ratio for the cheapest share class has a decent head start on its two largest active-based rivals, T. Rowe Price Retirement series (0.47% for its cheapest share class) and Fidelity Freedom (0.51%). Notably, both peers have been seeing large outflows from their mutual fund series, although T. Rowe has seen steady positive contributions to the collective investment trust version of the series.

While they provide a decent head start, low fees don’t guarantee outperformance. American Funds has managed to provide both. Its performance over the last decade has blown Vanguard Target Retirement, the industry’s largest series, out of the water. Exhibit 3 shows the average category rank of both series over the one-, five-, and 10-year periods ending Dec. 31, 2020.

The average category rank of the series’ cheapest share class from the 2060 vintage through the 2020 vintage was first over the 10-year period, a remarkable feat. Vanguard has been no slouch over that period, but it’s consistently been outpaced.

Strong stock selection, resilient bond funds, and positive results in allocation funds offering exposure to bottom-up tactical shifts have helped American Funds. The series’ persistent tilt to mega-cap stocks as they have soared past smaller-cap equities over the past decade also was fortuitous. Its 2050 vintage’s average market cap for the trailing decade, for example, was about $10 billion more than that of its typical peer’s. By the end of 2020, though, its $90 billion average market cap was nearly twice the category average of $57 billion. The series’ underlying funds also have large asset bases, which could make it harder to pivot to smaller companies if those come back into vogue.

The Small Company Challenge

Since November, small-cap stocks have surged relative to larger-companies, as shown in Exhibit 4.

Exhibit 4: Small-Cap Surge Since November

- source: Morningstar Direct as of Jan. 31, 2021

This trend has indeed proven to be a bit of a headwind for the series. Exhibit 5 shows the average category ranks for the series from November 2020 through January 2021.

While three months is a blip on the radar for an investment designed to last 45 years or more, this brief interlude is notable insofar as it suggests that American Funds’ strategy isn’t bulletproof. Investors should be wary of the challenges a prolonged rally in smaller companies can pose.

That said, American Funds has more arrows in the quiver, and we continue to have a high degree of confidence in the series’ long-term prospects, as demonstrated by the Morningstar Analyst Ratings of Silver for the series’ cheapest share classes. The firm possesses an industry-leading arsenal of underlying equity and allocation managers underpinning its series, and has deployed them to great effect: Even when there have been headwinds, underlying managers have ensured the series never lags too far behind. At least for the past decade, a bet against this group was a losing one.