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Can Pricey Target-Date Funds Be Competitive?

Some of these one-stop retirement offerings are way too expensive.

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The mutual fund industry has long seized on trends in the market, rolling out funds to capitalize on heightened investor interest. While the tech-fund craze of 1999 and 2000 was perhaps the most egregious example, there have been others: Both emerging-markets and biotech funds first came out en masse in the early 1990s, right after those corners of the market had surged.

The latest hot fund type, however, is actually rather sedate: Target-date funds. Designed as one-stop shopping options, these funds hold a broad spectrum of stocks and bonds (typically by buying other offerings within the same fund family), and their asset allocations grow more conservative as the funds approach the target date included in their names. These funds have gained favor among 401(k) providers and wary investors in the wake of the bear market; more than two thirds of the 155 target-date funds in Morningstar's database are less than three years old, and we introduced three new fund categories in March 2006 to address this phenomenon.

Singling Out Expensive Choices
Because these funds are broadly diversified, investors are far less likely to get burned by buying a target-date fund fresh off the shelf than previously trendy offerings. That said, it's important to note that some target-date funds are significantly riskier than others--and the bolder ones tend to be more expensive. Such funds present a conundrum: While they offer the potential for higher gross returns, their loftier expense ratios will certainly cut into gains--particularly because these funds are designed to be held for decades. For example, the A shares of MFS Lifetime 2040 (MLFAX) charge 1.43%, making it one of the priciest target-date funds around. One reason: The fund has 99% of its assets invested in stock funds, which tend to charge higher fees than bond funds. (Meanwhile, the typical 2040 target-date fund has an 86% stake in equities.) It also has a 20% stake in foreign-stock funds like  MFS International New Discovery (MIDAX), which are costlier than their domestic-stock counterparts. (Although the target-date fund invests in the cheaper Y shares of its siblings, the fund adds on a 0.35% 12b-1 fee that roughly matches that of the underlying funds' A shares.) It's worth noting that MFS' target-date funds turn conservative at a more-rapid rate than many of their rivals, so MFS Lifetime 2010 (MFSAX) is far cheaper than the 2040 option. The 2010 option's price tag, at 1.09%, is lower than the front-load norm for the category, but it still strikes us as high for a fund with just 37% of its assets in equities.

Another target-date fund that fits the higher-risk, higher-cost profile is Hartford Target Retirement 2030 (HTHAX). While it doesn't have a big stake in foreign offerings, the fund's weighting in Hartford's small- and mid-cap funds is well above the group norm. That tilt, along with a 0.2% management fee layered on top of the underlying funds, pushes its expense ratio to 1.4%. We're not fans of target-date funds that levy additional management fees; the underlying funds already charge management fees, and target-date funds are very low-maintenance vehicles once they're set up. Also, unlike MFS' offerings, Hartford's target-date funds aren't slated to get much cheaper over time; Hartford Target Retirement 2010 (HTTAX) charges 1.3%--8 basis points higher than the inflated median for front-load funds in the category.

A third example is Seligman's series of target-date offerings, which invest in exchange-traded funds (ETFs). Because ETFs tend to sport low expense ratios, investors might expect to pay a very modest price tag for Seligman's funds, but they'd be wrong. The A shares of Seligman TargETFund 2025 (STKAX), for example, charge a lofty 1.35% (the underlying ETF holdings cost just 0.26%). The primary culprit for that inflated price tag is a 0.5% management fee; Seligman's management team makes adjustments to the fund's asset allocation in an attempt to add value. However, it could be difficult for the team to overcome the fees imposed over and above the ETFs' expense ratios. The fund's makeup, however, is certainly bold: Nearly half of its equity portfolio is comprised of small and mid-caps, and it has one of the lowest average market capitalizations among all target-date funds.

Which Came First?
The issue with pricier target-date funds that take on more risk is akin to the classic chicken-and-egg question. Are such offerings more expensive simply because they invest in the types of funds that tend to be more costly? Or, conversely, have they been designed with a bolder look in an attempt to outperform cheaper rivals?

We think the answer is a little of both. Fund shops have typically told us that the allocations for their target-date funds are based on projected future risk/return profiles for stocks, bonds, and cash. Some firms strongly believe that investors need to hold heavier equity stakes as they approach retirement, as well as substantial stakes outside of large-cap domestic stocks and investment-grade bonds, in order to meet their financial goals. However, it's worth noting that many target-date funds tend to emphasize those areas in which a firm is particularly strong. That's fine and perhaps even desirable, but investors need to be aware that considerations other than optimal portfolio construction can influence the complexion of their target fund. What's more, fund families that tend to charge higher fees are likely looking for a performance edge in this fund industry niche, which has become increasingly competitive--thus they take on additional risk. It's too soon to say whether bolder, pricier target-date funds can overcome their cost hurdle, given the short track records of most of these offerings, but we'd remind investors that the higher expected returns of foreign stocks and smaller-cap names won't necessarily materialize.

Our advice when shopping for a target-date fund is two-pronged. We agree with the idea that investors ought to invest in offerings with substantial weightings in equities, particularly within areas that are less correlated to domestic-stock benchmarks such as the S&P 500. However, they also need to consider their own risk tolerance. Most importantly, we think they need to hold the line on costs. If investors look hard enough they can still find reasonably priced, even cheap, target-date offerings that offer such diversification. We continue to be most impressed with T. Rowe Price's and Vanguard's target-date lineups. Thus far, however, we've generally been disappointed with the expense ratios of broker-sold options, which are generally among the newer funds in the group. Perhaps they'll become cheaper if they attract more assets.

Greg Carlson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.