Morningstar’s Favorite Target-Date Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Target-date funds continue to be one of the bright spots within the mutual fund industry. Joining me to discuss some recent research on the topic is Jeff Holt. He's associate director of multiasset strategies in Morningstar's manager research group. Jeff, thank you so much for being here.

Jeff Holt: Oh, thanks for having me.

Benz: You and the team have recently come out with a new report on target-date funds where you look at these incredible trends in terms of asset flows. We've seen a lot of investment managers losing assets, but target-date funds have been a bright spot. Let's talk about 2015.

Holt: So, in 2015 target-date funds had an all-time high in terms of record flows. They saw $69 billion in mutual fund inflows, mutual fund assets inflow into the strategies in 2015. A lot of that has been because of their being a default investment in a lot of 401(k) plans and other defined contribution plans. Basically, every paycheck invested are contributing to the assets, and that has contributed to continued growth in the area.

Benz: Okay. You spotlighted some of the largest providers. You say that the "Big Three," you call them, are still the biggest entrenched providers. That's Fidelity, Vanguard, and T. Rowe Price. Let's talk about how they built that footprint in the business.

Holt: Vanguard, Fidelity, and T. Rowe Price, so the Big Three, they all have record-keeping services for defined contribution clients. That allowed them to get a foothold into the industry early on. Collectively, those three account for 70% of the target-date mutual fund assets, but we have seen that number slowly decline over time as there's been more competition in this space.

Benz: In the report, you talk about the role of target-date funds in terms of perhaps causing capacity issues at some of the underlying holdings in the target-date series. Let's talk about that issue. It's a concern not just for people who are investing in the target-date funds, but maybe the people who are holding the underlying funds in some other type of account.

Holt: Yeah, so that's one thing that we have identified. We looked at the underlying holdings and we found that there's numerous closed funds that are being held within target-date funds, and that would signal that there's a capacity constraint. As target-date funds have a clear runway for continued growth as investors continue to contribute as it being a default investment in defined contribution plans, the question arises, at what point do you no longer invest in some of these underlying funds and you have to take smaller positions in those, and so it will look a little bit different than it has in the past. And so that's something that we're keeping a close eye on, and we think investors should pay attention to that. And that's going to be particularly an issue with larger series that have quite a big asset base, and also those that use a lot of active strategies underneath the hood, because there is more capacity constraints with some of those underlying funds.

Benz: But it would tend to be less of an issue or a non-issue even if you're investing in some sort of a target-date fund that is investing in index funds?

Holt: Yeah, index-based funds typically have a larger capacity, so we don't foresee that being such an issue for those funds.

Benz: OK. Let's talk about fund fees because that's another trend that we want to see moving in the right direction. As assets have been flowing into target-date funds, we'd want to start seeing expenses come down. Have you and the team observed that trend, that downward pressure?

Holt: Yeah. Year after year, we continue to see fees go down and down and down, and it's for a few reasons. We've seen target-date managers lower their fees or launch less-expensive versions of their strategies. Maybe combine some passive and active strategies to be competitive, because there is heightened attention to fees with all the lawsuits going on in the industry; there's a really heightened attention to fees. And part of contributing to the low fees is the investor demand to pay low fees or pay competitive costs for it. So in the report, we highlight the importance of understanding what you're paying for and that you're paying a good price for what you've selected.

Benz: OK. One thing that you highlighted in this report was that role of what are called collected investment trusts, or CITs, in the target-date landscape. Let's talk about first what is a CIT for people who may not be familiar with them. And also, how they're different from some of the mutual-fund-based target-date funds, and perhaps how they're similar.

Holt: Yeah. So a CIT is simply a different investment vehicle. In many cases it's... Well, it's typically available to institutional investors. An investor might see this in their 401(k) plan, for example.

Benz: They might not know it's a CIT. I think that's a common problem.

Holt: And they might not know it's a CIT. They might not be able to have a ticker to look it up. But in many cases, it's the same team and same approach that's being applied to the mutual funds to the CITs. And this year's report, we broaden the landscape and looked at assets in CITs, and we found that there are quite a bit of assets in CITs, and it actually provides more color into the landscape. And we found that certain series, like the target Vanguard series, they have an even a bigger lead over their peers in terms of total assets when you factor in the CITs. And there are certain other players, like BlackRock, that are much bigger players when you factor in their substantial amount in CITs.

Benz: OK. You mentioned Vanguard and BlackRock, and those two firms in terms of their target-date series actually are the only two lineups that earn Gold ratings. Let's talk about what were the factors that influenced those series' high ratings.

Holt: Yeah. So both of those series are Gold-rated, but they're not Gold-rated just because they're index-based series. It's really about the process and the approach that goes behind in building the glide path and building the underlying building blocks to create the series. And both those series have deep teams with a lot of research, and they're continually conducting more research on making their target-date series very competitive.

Benz: Let's talk about the rung below those Gold-rated series. I know T. Rowe Price makes the cut there.

Holt: Yeah. So the JP Morgan SmartRetirement series, the American Funds Target Date Retirement series, and the T. Rowe Price Retirement series each receive a Silver rating, and those are all invested in actively managed underlying funds. And taking a look beneath the target-date level at the underlying funds, we found that they have good, solid building blocks. Part of the report this year was to look at the best practices. Our best practices in identifying the top target-date providers and one of the aspects was to look underneath the hood and look at the analyst ratings of the underlying funds to gauge what the expectation should be for future performance. Because we do believe that on a standalone basis, the underlying funds should have some merit.

Benz: So you are looking at funds that are under analyst coverage, and if those funds are highly rated or if a big portion of a series consists of highly rated funds, that would be kind of a feather in its cap?

Holt: Yeah, it would definitely be a positive aspect to have a lot of solid funds that Morningstar analysts have rated and identified as being good potential for future outperformance.

Benz: OK. Jeff, this part of the industry's really growing in importance. Thank you so much for being here to share your insights.

Holt: Thanks for having me.

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