Are Fidelity's Target-Date Funds on the Mark?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

If Fidelity manages your 401(k) plan, it's a good bet that it includes some Fidelity Freedom Funds. Joining me to share his insights on Fidelity's target-date lineup is Christopher Davis. He is a senior mutual fund analyst with Morningstar.

Chris, thank you so much for being here.

Christopher Davis: Well, thank you for having me.

Benz: Chris, let's start by talking about the key pluses of Fidelity's Freedom Funds lineup?

Davis: Well, I think the key plus is, you're getting a really seasoned management team, and that's important with any target-date fund. They're designing the fund's asset allocation, they're really … overseeing the quality of your investment experience. And so, you have folks that have been around for a long time, and they're backed by a huge team of asset allocation specialists. And I think Fidelity spends a lot of time getting the glidepath--which is the investors' transition from a stock-heavy to a bond-heavy portfolio, as they age--I think they spend a lot of time getting that right.

And one advantage Fidelity has as a big organization is they have a lot of data with the lot of participants, and they've tailored their glidepath based on how people actually behave. So they know investors have this tendency to panic when times are tough. So, their glidepath is a bit more conservative than perhaps the quantitative models would have indicated that they should be, just based on how investors actually have behaved.

Benz: Chris, you've noted that one difference with Fidelity's target-date lineup is that, for the near-dated funds, the ones that are more bond-heavy, they are more conservative than some of their peers. What's going on there?

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Davis: Well, as you mentioned, Fidelity's glidepath, the path that investors take from an equity-heavy to a bond-heavy portfolio, pretty much follows industry norms until investors are in retirement, and then it becomes much more conservative. It is more bond-heavy; it has a huge cash stake. And so the idea behind that is, investors in retirement care about preserving their capital and not losing money above all else, so their plan is designed to address that.

The risk is--and this is what other retirement plan providers like, let's say, T. Rowe Price might note--is that people are living a really long time. If you make it to 80, you have a really high likelihood of making it 85 or 90. And so, if you have a really conservative allocation, you have a higher risk of outliving your savings. So, that's the risk there.

But on the other hand, you might be able to sleep more easily with the more conservative Fidelity-like allocation.

Benz: And how about cost? How does the series stack up from that perspective?

Davis: Like Fidelity in general, it's not necessarily an industry leader on cost--Vanguard usually wins that award--but Fidelity is below average in cost. So that's another intrinsic advantage it has.

Benz: When you look at the key drawbacks of this lineup, what are the things that have kept the Morningstar analyst team from putting the Fidelity Freedom Funds out there as best-of-breed target-date funds?

Davis: One issue that we had that Fidelity has done a pretty good job cleaning up is we thought that their lineup was a bit cluttered, and by that I mean the actual underlying holdings, the funds that the Freedom Funds invest in, was very sprawling, lots of overlap. And so they have streamlined that. But the problem that does remain is that the underlying holdings are kind of bland, generally nondescript. They are not Fidelity's best in breed.

Benz: Let's discuss these holdings--they are called Series Funds--that populate the Freedom Funds' portfolios. What are those funds, and how are they different from some of the marquee Fidelity names like Low-Priced Stock or Contrafund?

Davis: Right. Well they are different in the fact that Series Funds are designed for use only by Fidelity's Freedom Funds or any other asset allocation strategies. So they're internal funds. They're very benchmark-conscious. So the Freedom Fund managers like this because it makes the funds' behavior predictable. So if the large-value portfolio is tied to the Russell 1000 Value Index, for instance, you know how it's going to behave.

The risk of this approach is that if you're too much like your benchmark, you may have a difficult time outperforming. And so that's the balance that Fidelity is trying to navigate. I think that they've only done a decent job at producing respectable results.

Benz: There are some changes afoot, though, that you have noted that they are going to be putting some of those top-tier managers who we really like onto the Freedom Funds. Let's discuss those changes, what they are, and when they will go into effect?

Davis: Well, Fidelity hasn't made it official. All they've said is they are creating these Series Funds, one of which will be led by Fidelity Contrafund's Will Danoff and another will be led by Fidelity Low-Priced Stock's Joe Tillinghast, and these are, in our opinion, Fidelity's two best equity managers. We've criticized them for not including these great managers in their lineup.

Fidelity hasn't officially announced that they will be part of the Freedom Funds, but you can kind of put two and two together that they will somehow likely play a role. These funds are slated to launch in December, and so if history is any guide, we should see these creeping their way, perhaps slowly, into the Freedom Funds sometime in 2013.

Benz: And it's your view that that would generally be a good thing?

Davis: Right. So you'll have access to some of the best managers at Fidelity. I think what bears watching is--and the reason why you haven't seen a Danoff or Tillinghast previously--is they run a lot of money. So, this is going to be adding another duty to their plate, a big slug of assets. This is one of the only areas of growth Fidelity is seeing. So, it will tax those managers' abilities, I think, and that is something that bears watching. But on balance, it's a good thing for Freedom shareholders.

Benz: There are also index-oriented versions of these Freedom products. What are those, and how good are they?

Davis: The Fidelity Freedom Index Funds, we don't rate those, but they have a lot of the great attributes that I mentioned earlier in terms of having a very thoughtfully conceived glidepath. But the only difference is, the underlying holdings are Fidelity's Index Funds, and Fidelity is a leader on the index front on low costs. So, you get the benefit of a great well-conceived asset allocation at much lower costs. You don't have to worry about subpar underlying holdings; you're getting really strong, cheap index funds. So, if you have that option as part of your plan, my instinct would say that the Freedom Index would be a better alternative to the active option.

Benz: Okay. Last thing I want to cover with you, Chris is, I know we like Fidelity's bond funds quite a bit. So, does that mean by extension that we like the near-dated target-date funds a little better, because they are more bond-heavy?

Davis: Right. So if you look at the near-dated funds, they're dominated by bond funds, led by really seasoned, capable managements. So, the nice thing about Fidelity's Freedom Funds is they only get better the longer you're in them. So, especially for investors now that are looking to be a little bit more conservative, that are approaching that retirement date, I think you're investing kind of at the best time to own these funds, because you're getting access to a really strong part of Fidelity's lineup.

Benz: … Assuming things stay the same, that they'll just continue to improve as they get more bond heavy.

Davis: Exactly. I mean that's a risk of any active target-date strategy is, you're putting faith in the asset manager that they'll be able to improve or at least keep up their act over time. So, that's that appeal of the Freedom Index Funds, it doesn't matter. Those will always be cheap, low-cost, solid options.

Benz: Well, Chris, thank you so much for sharing your insights today. I know these funds are of great importance to a lot of people, so it's great to hear from you about this.

Davis: Well, thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.