Solution Funds Deserve Better

The Blame Game When investors have bad experiences with mutual funds, they generally blame the funds. And with good reason. Most active mutual fund managers, for most time periods, in most asset classes, have trailed their benchmarks. Shareholders have responded by complaining about their actively run funds and by swapping such funds for indexed substitutes. In that, they can scarcely be faulted.

So, too, can shareholders be pardoned for grumbling about mistiming their mutual fund purchases. As has been widely chronicled, fund investors have the regrettable tendency of buying into asset classes high and selling them low. (The classic case was buying U.S. stock funds heading into 2008, then redeeming such funds while buying alternative investments in the years thereafter.) Fund marketing has facilitated many such mistakes, as fund companies tend to promote what has been winning and underplay what has not.

In those instances, it’s fair to say that investors have been ill-served by the mutual fund industry. But sometimes, it is the funds that deserve better.

No Sales Such has been the case with so-called "solution" funds--funds that describe themselves not by the investments that they hold but rather by the goals that they hope to achieve. Target-date funds are one example. Other versions of solution funds include target-risk funds, absolute return funds, and managed-payout funds.

Those funds have been shunned by both investors and their financial advisors. Wait, you say, that statement is rubbish. Target-date funds have been an enormous sales success, attracting so many assets that Morningstar publishes white papers on their status. That is so--but those monies come because 401(k) sponsors make target-date funds their plans' default investments. On their own, investors do not buy target-date funds, nor do financial advisors recommend them. Almost all target-date assets come through 401(k)s.

The remaining solution funds possess, collectively, 29 cents. Well, slightly more but, by the standards of the major fund companies, only slightly. Take managed-payout funds. Vanguard Managed Payout VPGDX contains $1.7 billion, which is an average month’s sales for the major Vanguard stock-index funds; Schwab’s three offerings range from $50 million to $100 million; and Fidelity’s entries are smaller yet. The industry’s target-risk and absolute return funds are small potatoes, as well.

The solution funds’ performances have been much better than their assets would indicate. True, most absolute return funds have disappointed. They charge premium prices, in the form of above-average expense ratios, while using strategies that produce low-to-medium returns even in the best of times. (Ideally, those low returns would be accompanied by even lower relative risk.) That is a failing combination--and absolute return funds have indeed failed.

Target Dates: Performing Well But the other solution funds have fared well.

Target-date funds took a public-relations beating after 2008, when the short-dated funds from several families fell further than anybody expected. Part of that disappointment owed to the fact that the overall stock market fell further than anybody foresaw, but part was legitimate, as the affected funds had been too aggressive. But often lost in that discussion was that the biggest problems occurred with the smaller providers. The industry leaders stayed on track.

And since then, target-date fund results have been solid. Over the past five years, the 2020 and 2025 target-date categories have gained an annualized 7.7% and 9.1%, respectively. That is only slightly behind the 9.3% annualized return achieved by the 50% to 70% equity allocation Morningstar Category (otherwise known as traditional balanced funds), and far ahead of the 5.1% gain for the admittedly woeful tactical-allocation group. At the longer dates, all target-date flavors from 2035 onward have outlegged the 70% to 85% equity allocation category.

Since 2008, tens of billions of dollars from discretionary retail accounts have flowed into tactical-allocation funds. Almost none has entered into target-date funds. The investment results suggest that exactly the opposite should have occurred.

Ditto for Managed Payouts Managed-payout funds are also underappreciated. The would-be category--it currently lacks enough members to qualify for its own Morningstar grouping, which means that managed-payout funds are scattered across several categories--had the misfortune of coming to market in 2007. That led to an immediate performance pratfall, redemptions from early investors, and purgatory in the wilderness that has yet to be relieved. But there is much there of interest.

Fidelity Income Replacement Fund 2042 FIXRX serves as one example. Scheduled to liquidate in 2042 (some managed-payout funds are run in perpetuity, while others have official termination dates), the fund is designed for those who wish to withdraw cash from a nest egg, while leaving others to manage the investment decisions. The fund achieves its distributions through a combination of dividends, capital gains, and returns of capital, at an annual expense of 0.67% annually.

An attractive deal? Whether you think so depends upon how well you believe you could accomplish this task yourself. You would need to find an asset mix that is appropriate for the time frame and requirement of a (fairly) steady monthly withdrawal schedule, and you would need to have a large enough portfolio to achieve acceptable diversification. Suffice it to say that the fund’s offer is at least reasonable--and that, while making its required monthly payments, the fund’s total returns have been double those of the typical tactical-allocation fund. You could do much worse. Many investors have.

Active Can Be Good It's easy to understand why solution funds don't appeal to those who give financial advice, robo advisors included. They view it as their job to assemble the components of the more complex versions of mutual funds, not the role of a fund company. What's less clear is why shareholders who make their own decisions about investments aren't more enthusiastic about accepting a fund company's help. If the cost for a solution fund is right, the benefit is likely. Solution funds are one the best applications of active management.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.