Vanguard's Target-Date Funds Earn Top Marks

When Morningstar pulled back the curtain on its  20 new Target-Date Fund Series Rating and Research Reports today, Vanguard Target Retirement funds were standing in the spotlight, while Oppenheimer got the hook.

A brutal market environment in 2008 dug a wide trench between winners and losers, but target-date funds' performance in last year's market slide is only part of the story here. It's true that the Vanguard funds' losses were relatively slimmer, while Oppenheimer's funds took it on the chin. Oppenheimer Transition 2010 , a fund designed for investors retiring next year, lost a whopping 41% in 2008, which was a full 18 percentage points worse than the fund's category mean.

But the Morningstar Target-Date Fund Series Rating and Research Reports consider far more than performance in their evaluations. The methodology also evaluates the people, parent, portfolio, and price behind the funds. Target-date series that earn a Top rating have not only delivered good, risk-adjusted performance for shareholders, but they exhibit other best-practices that should make these funds stand out over the long term.

Management Matters
Morningstar begins its evaluation of a target-date series by examining the fund's management team. Fund series that earn Top ratings for People are run by managers who are experts in their fields. Morningstar looks not just at the named managers on the target-date funds; in cases where the target-date funds are funds of funds, the managers of the underlying funds are considered. In addition, we examine fund managers' pay plans and personal investments to see if they are structured so that each manager's primary incentive is to deliver strong long-term returns to shareholders, an industry best practice in our view.

Vanguard, American Funds, and T. Rowe Price stood out for their superior management teams, with each earning Top ratings for People. All three firms have high five-year manager-retention rates, and their target-date funds feature experienced managers likely to stay for the long term. In addition, the fund firms' pay plans align managers' own financial interests with shareholders'.

At the American Funds, for example, the average tenure for a manager running one of the target-date funds' underlying holdings is more than 23 years, and less than 2% of the firm's fund managers have changed in each of the past five years. Those trends should give target-date investors confidence that there's little flight risk associated with these funds' management talent.

Some series with lackluster ratings for People, including Fidelity Freedom, have managers at their firms that we like, but their funds aren't included in the target-date series. Fidelity likely left out managers like Joel Tillinghast of  Fidelity Low-Priced Stock (FLPSX) and Will Danoff of  Fidelity Contrafund (FCNTX) because their offerings have been closed in recent years and couldn't soak up the assets that have streamed into Fidelity's target-date funds. Even so, investors in this target-date series aren't getting Fidelity's A-team.

Manager turnover has been a problem for other series. DWS earned a Bottom mark for People because it's had trouble keeping strong managers. Indeed DWS' average manager tenure on its target-date funds was the lowest among the 20 series we graded, and its manager-retention rate was the second-lowest in the peer group.

Scrutinizing Corporate Culture
In addition to scrutinizing the managers behind a target-date series, Morningstar also takes a close look at the company offering the funds. Target-date fund series run by companies that put shareholders first and that consistently exhibit industry-leading stewardship practices are likely to exhibit such behavior within the target-date series, too. Within the Parent section, we evaluate four aspects of the parent company, including its corporate culture, its fund board's oversight, its communications with target-date shareholders, and its regulatory history.

Target-date series earning Top marks for Parent consistently put shareholders first because they charge reasonable fees, offer easy-to-own funds, and play to their investing strengths. T. Rowe Price, for example, earns top marks because its funds are built around the firm's well-established research process and feature prudent, actively managed strategies. T. Rowe doesn't launch trendy funds, and it charges reasonable fees, even on its smaller funds.

The worst mark for Parent went to ING, which has been focused on aggressively gathering assets in recent years, expanding its investment staff, and launching new funds. It also had a troubling 2006 run-in with regulators over payments that it made to a New York teachers' union group so the group would endorse and promote some ING annuity plans. The payments weren't disclosed, so the members of the group didn't know that they received biased advice.

Penny Pinching Is Wise
For core investments that one plans to hold for decades, it really pays to be cheap. Morningstar's research has shown that it's very difficult for higher-priced funds to outperform their peers over the long term. Even a very modest performance advantage becomes sizable when compounded over many years. To take a simple example, assume that a 25-year-old investor places $5,000 in a target-date 2050 fund, adds $3,000 to the account each subsequent year, and the fund earns a 6% compound annualized return over the next 40 years. The result would be $549,657. But invest in a different fund that earns the same total return but charges 50 basis points more in expenses per year, and the hypothetical investor would take home $480,264--a full $69,000 less.

Target-date investors seeking the lowest-cost option have one clear choice: Vanguard. The firm's funds are well-known for their low fees, and the target-date series' average annual expense ratio is just 0.19%--less than one fourth of the industry average. Among actively managed target-date series, the most competitively priced offerings based on Morningstar's methodology came from American Funds, American Century, JP Morgan, and T. Rowe Price.

On the other end of the spectrum is Oppenheimer. The target-date funds' A shares, which hold 44% of the series' assets, cost an eye-popping 1.44% on average. That's the highest front-load target-date levy among the series Morningstar tracks, and it's a big reason why the Oppenheimer funds came in last overall among the series we studied most closely.

Quality Is King
In the Portfolio section of the target-date series reports, Morningstar examines the quality of the underlying funds that typically make up a target-date series. Since target-date funds have become such important retirement-savings tools, it's critical to dig inside them to see if they've been seeded with quality investments or whether there are some mediocre funds lurking. (To be sure, a few target-date series own individual securities instead of funds, but that approach remains relatively rare.) We look at how well those underlying funds have performed in the past on a risk-adjusted basis. For this evaluation, we look to the Morningstar Rating, which is better known as the star rating. Target-date series that feature funds with high star ratings, particularly over the longer term, rate better than those with lower ratings.

The series that rate Top for Portfolio are the offerings from American Funds and American Century. The 21 funds featured in the American Funds' series had an average star rating of 3.90 out of 5, meaning that most of the funds in the series have outperformed their typical peer in recent years. Meanwhile, the 13 American Century funds' average star rating was 3.89.

None of the series we studied most closely earned a Bottom rating for Portfolio, suggesting that there is at least a minimum level of due-diligence taking place. There were, however, a couple of Below Average ratings: Fidelity Advisor Freedom and Principal. Fidelity Advisor Freedom, one of two series that Fidelity currently offers, features 18 funds with an average star rating of 2.81. The 26 funds in Principal's target-date series sport an average star rating of just 2.73.

Performance Rounds Out the Picture
There's much to target-date analysis beyond performance, but studying how well a series has done can be very informative. It's worth noting that most target-date funds are very young: Of the 47 target-date fund series that Morningstar tracks, 21 have been launched over the past three years. That means that much of the funds' performance history is skewed toward recent events. For example, fund series that had relatively fewer assets allocated to equities in 2008 have outperformed their peers. American Century and Wells Fargo, the two series earning Top ratings for Performance, are both relatively light on stocks as investors near and pass into retirement.

When equities are running, as they have been in 2009, the series with big allocations to stocks will shine. AllianceBernstein, which earns a Bottom rating for Performance, maintains one of the highest equity weightings through investors' retirement years. That was a painful allocation in 2008 but may ultimately help investors' savings last longer because an equity-heavy portfolio could rack up bigger gains over a long period of time.

Asset allocation is a big driver of returns, but of greater concern to Morningstar is when there's much more to the performance story. Again we return to Oppenheimer's steep 2008 losses. Those were caused not only by a high asset allocation to equities but also by a serious misstep by a key holding in the funds aimed at investors nearing or in retirement.  Oppenheimer Core Bond (OPIGX) turned in devastating losses because the bond fund took on too much risk and was stung in 2008's credit crisis. To make matters worse, it wasn't up-front with shareholders about the gambles that it was taking.

Over the longer term, as 2008's records recede and target-date series gain longer histories, Performance ratings are likely to smooth out and the comparisons among Performance ratings will become more meaningful.

The Big Picture
For the series earning lower ratings, there's work to be done in more than one area to bring those target-date funds up to the best-practices standards held out by some competitors. Morningstar reviews the series quarterly as part of the Target-Date Fund Series Ratings and Research Report, so we'll quickly reflect which series are improving--and which are holding steady--in each of the five areas.

More detail on each of the 20 series above is available to Morningstar.com's Premium Members  here. If you're not a Premium Member, give it a try free for 14 days.