Can the House League Beat an All-Star Lineup?

Professional investors--pensions, endowments, institutions, and probably you, too--insist on having a variety of firms' money managers represented in their portfolios. Such an approach allows one to cherry-pick experts by asset class and minimizes the risk that something unexpected, like a manager's departure, poor execution or even fraud, would derail an entire portfolio.

Several target-date fund series have taken a similar approach, including funds from a variety of shops within their lineup. Firms such as Wells Fargo and Vantagepoint only use subadvisors to run their funds designed for retirement savings. Others, including ING, John Hancock, MassMutual, and Principal, mix their own in-house managers with others from unaffiliated firms. In financial parlance, target-date series that feature managers from many firms are considered to have an "open architecture," while those featuring only in-house managers have "closed architecture."

What Do Architects Have to Do with Investing?
It's understandable why an investor or target-date series would like a variety of firms' money managers included in a target-date series, especially because few firms are industry leaders in each of the subasset classes typically included in a target-date fund. But the fund company offering the series has a lot of reasons to choose the closed-architecture format. The target-date provider of a closed series gets to keep all the management fees from the underlying funds rather than directing some of them to other firms, and it has more control over the managers and investment processes.

Given the potential conflicts, Morningstar conducted an analysis of open- and closed-architecture target-date series to determine whether open-architecture series have demonstrated a performance advantage over closed-architecture formats. In an extensive report on target-date series released today, Morningstar analyzed several factors, including risk-adjusted returns, performance attribution, underlying Morningstar Ratings for funds, and overall Morningstar Target-Date Series Ratings. (That last rating is limited to 20 series.) Morningstar found that open-architecture series did not have a meaningful edge when judged by any of these measures.

Closed, Open, or Ajar?
Morningstar began by looking at three-year risk-adjusted returns, where series' returns are penalized for poorer returns when markets are declining. Among the 10 series with the best three-year risk-adjusted returns through Dec. 31, 2009, only three are either partially or wholly run by subadvisors in an open-architecture format. Moreover, two of these three (Wells Fargo and ING Index Solution) don't use a freewheeling, go-anywhere approach to choosing managers; they are index-based offerings that employ a single external subadvisor. Among the bottom 10 performers, meanwhile, five use at least some funds run by managers with no affiliation to the target-date fund's parent company.

Top 10 Risk-Adjusted Return Rank and Series Architecture

Bottom 10 Risk-Adjusted Return Rank and Series Architecture 

It's true that these risk-adjusted returns are influenced by the asset allocation (or "glide paths" in target-date lingo) of the various series. Target-date funds with equity-heavy asset allocations were among the worst performers in 2008's market slide, and those results are reflected in the three-year risk-adjusted returns noted above. But even if that effect is taken out of the equation through Morningstar's analysis of performance attribution, which better isolates how much of a series' outperformance or underperformance is attributable to the managers of the underlying funds, the data reveal no advantage to open-architecture series.

The same result came through when we looked at the Morningstar Ratings ("star ratings") of the underlying funds of the various series and when we looked at the latest Target-Date Series Ratings issued by Morningstar to 20 series based on Dec. 31, 2009, data. The latter are more holistic and comprehensive evaluations, covering both quantitative and qualitative aspects of a series' performance, fees, management quality, and stewardship practices.

Assessing the Results
Several factors may explain why open-architecture target-date series haven't demonstrated a performance edge. For one, it can be expensive to hire subadvisors--especially truly exceptional ones, and the series' subsequent expense ratio may be higher and act as a further drag on performance. In addition, it's not easy to choose and combine subadvisors that together will consistently outperform. Such portfolio construction is an art that's perfected over years and decades. Finally, it's still early days for target-date series--many have yet to reach their third birthday. As these funds' records lengthen, series with open architecture may demonstrate a performance advantage.

It's also worth noting that while the data does not suggest that open-architecture series have a performance advantage, it also does not indicate that they have a consistent disadvantage. Theoretically, the open-architecture series should be superior at risk management, though that hasn't played out so far across the peer group. That said, one open-architecture standout is Vantagepoint, which has benefited from strong manager selection, a relatively conservative glide path, reasonable (though recently increased) fees, and a stellar and experienced investment culture. Looking more broadly, however, Morningstar can't make a strong argument in favor--or against--the open-architecture management model for target-date series.

The following analysts contributed to this article: Josh Charlson, senior fund analyst; David Falkof, fund analyst; Michael Herbst, associate director of fund analysis; Laura Pavlenko Lutton, editorial director; John Rekenthaler, vice president of research; and Gregg Wolper, editorial director.