Is Your Target-Date Fund Quality to the Core?

Target-date funds are complex investments. The funds' asset-allocation shifts as an investor nears retirement, following what's known in the fund industry as a "glide path." Picking a fund with a glide path that fits one's tolerance for risk and retirement savings habits is tricky enough, but investors also need to weigh the structure and quality of the target-date funds' underlying holdings.

As Morningstar noted in its target-date industry survey, which was released last week along with 20 new Morningstar Target-Date Series Ratings and Reports, there are many complexities and nuances to the ways that target-date firms adapt their asset-allocation choices to actual portfolio allocations. As with glide paths, there are several possible--and potentially appropriate--approaches that target-date fund series may take, and investors should look closely to see if the approach of a given target-date series fits with their own investment preferences.

Fund of Funds or into the Pool?
One thing to consider is whether a target-date series uses a fund of funds structure. The roots of the industry lie in that direction, as the Big Three of Fidelity, Vanguard, and T. Rowe Price, which represent more than 70% of industry assets, each populate their target-date funds with existing single-strategy mutual funds. For the most part, the fund of funds model has been adopted by later entrants as well, although often the newer players have lacked a full stable of appropriate in-house funds from which to select.

Recently, however, some fund families have experimented by doing away with the fund of funds structure and instead hold securities directly through a master pooling arrangement. Using a master pool frees the target-date funds from paying the stated fees charged by the underlying funds--and thus potentially passes on its cost savings to investors. On the other hand, it can be tricky to implement such a structure when using a number of active managers. It can also be more difficult for investors and fiduciaries to judge the strengths and weaknesses of the underlying managers when a master pooling structure is in place.

Going the Active or Passive Route?
A more significant question is whether a target-date series uses active or passive management to run the underlying portfolios. On that front, the target-date industry remains strongly committed to active management. There are more target-date fund series that have essentially 100% of their assets invested in actively run funds than there are series that have even a moderate stake in passively run assets. However, the current investment popularity of indexing strategies, along with the political pressure to include more indexed options within 401(k) plans, appears to be having an effect. Recently TIAA-CREF and Fidelity--two firms with existing, actively managed target-date funds--announced plans to offer fully indexed target-date series. In addition, some firms, including John Hancock and Schwab, have mixed in substantial proportions of index vehicles alongside actively managed funds.

In-house Talent or Guns for Hire?
Another distinction we've found is whether a target-date firm chooses to run the assets in-house, or to use external subadvisors. Because target-date funds invest across a range of asset classes (some fairly specialized, such as commodities, global real estate, high-yield bonds or preferred securities) it is questionable whether any fund family truly possesses the expertise, experience, and resources necessary to invest each of those asset classes effectively over the long haul.

Current industry practices are quite varied. Several major fund families use all in-house funds, such as Vanguard, T. Rowe Price, Putnam, Fidelity, and American Funds. In contrast, Vantagepoint (whose funds are available only to public-sector employees) uses only third-party subadvisors, and John Hancock and Principal opt for a combination of in-house management teams and external subadvisors. It's logical to think that a company lacking expertise in managing a particular asset class should seek a stronger subadvisor to manage that slice of the target-date portfolio. Yet evaluating and monitoring subadvisors also requires specialized expertise and experience. The manager selection teams and processes at some target-date companies are significantly more advanced than at others.

Finally, even those families that use only proprietary funds take diverging paths when it comes to availing themselves of their best and most-popular funds. Fidelity, AllianceBernstein, and DWS do not offer their target-date investors many of their best managers. T. Rowe Price does better on that front, but a couple of its top managers are not employed by the target-date series, even though they subadvise competitors' target-date funds!

The issue of the quality of the underlying funds in target-date fund portfolios will become more significant as the industry grows, and Morningstar believes the area deserves more scrutiny. While the glide-path decision made by the target-date allocators is the dominant factor in determining short-term performance, series that also offer topnotch underlying managers can give their investors an edge. Conversely, there were cases in 2008 in which a defensive asset allocation could not fully protect a target-date series from weaknesses in its underlying fund lineup.

As with all else in the target-date industry, the range of quality of underlying funds as measured by the Morningstar Mutual Fund Star Rating is quite large. At the bottom of the scale, the funds that make up the Goldman Sachs target-date family have an average underlying rating of only 1.73 on Morningstar's 1-to-5 scale, while at the top Franklin Templeton, MainStay, and American Funds are each between 3.9 and 4.0.

Target-Date Fund Series  by Percentage of Assets in Active Strategies
	% Active
American Funds	100.00
BlackRock	100.00
MassMutual	100.00
RiverSource	100.00
MFS	99.99
TIAA-CREF	99.93
Putnam	99.87
Oppenheimer	98.99
Principal	98.72
JPMorgan	98.59
Columbia	97.98
Fidelity Advisor	96.69
Franklin Templeton	96.05
American Century	95.23
ING	94.30
Fidelity	93.08
Guidestone	90.68
MainStay	86.29
T. Rowe Price	80.62
John Hancock	78.87
Vantagepoint	77.07
Schwab	77.00
DWS	68.20
AIM	64.52
Barclays	62.52
State Farm	61.45
Nationwide	7.14
Vanguard	2.60
Seligman	0.63
Source: Morningstar, Inc. Only target-date series that use a fund-of-fund structure are included.

Josh Charlson, Michael Herbst, and John Rekenthaler contributed to this article.