Passive / Aggressive

When considering indexed TDFs, it doesn’t have to be an all-or-nothing proposition

“With all the light being shined on fees and fee disclosure, plan sponsors are aware that they need to make sure they are putting participants in funds with reasonable fees,” says Jeremy Stempien, director of investments at Ibbotson Associates Inc., a subsidiary of Morningstar Inc. “Inevitably, that leads one down the path to looking at passive products.”

While actively managed target-date funds (TDFs) still hold far more assets overall, index-based series have grown faster than active series have over each of the past three years, according to Morningstar’s “Target-Date Series Research Paper: 2012 Industry Survey,” released in May. “Passive series generally have been gaining assets at about twice the rate of active series; in 2011, passive series grew by 19%, while active series grew 11%,” the paper says.

“There is definitely a trend that we have seen pick up, a movement to swap out active target-date funds for indexed target-date funds,” says Beth McHugh, vice president of market insights at Fidelity Investments. “Like many trends, we see it first with the larger companies,” meaning those with plans that have at least $1 billion in assets and 25,000 or more employees.

Sponsors’ fiduciary desire to get good value—the right blend of cost, return and risk level—for automatically enrolled participants in their target-date funds explains much of it. Many target-date investors were defaulted into those funds when auto-enrolled in a defined contribution (DC) plan. “In the first quarter of 2012, more than one out of four participants held 100% of their assets in a target-date fund,” McHugh says.

As of first-quarter 2012, passive retail TDFs had $123 billion of $429 billion in total retail target-date assets, with another $40 billion or more likely in collective trusts and similar vehicles, Stempien says. (He labels as passive for that calculation a target-date fund in which all underlying investments, except short-term cash, are passive.) Eight of 45 retail target-date series currently have less than half their exposure to active investments, he says.

Fiduciary issues also have motivated sponsors of 403(b)s, as that type of plan moves to a more 401(k)-like approach. An emphasis on instilling a prudent fiduciary process for investments has led plans to favor lifecycle funds versus annuities, says Tim Walsh, a TIAA-CREF managing director. “A lot of this is driven by the ‘defensible posture,’” he says, of their desire to avoid lawsuits.

Sponsors thinking about switching to indexed target-date funds as a qualified default investment alternative (QDIA) should consider these six key factors:

1. Indexing can give participants major fee savings. Retail target-date funds have an average fund expense ratio of 83 basis points, down from 86 basis points a year ago, Stempien says.

“A purely passive target-date fund is probably going to be in the 10- to 20-basis-point range,” says Josh Cohen, defined contribution practice leader at Russell Investments. “A purely active target-date fund is probably going to be in the 50- to 80-basis-point range.”

Fidelity currently caps total expenses for its Fidelity Freedom Index Funds, including acquired fund fees and expenses, at 19 basis points, a spokesperson says. Fidelity bases expense ratios for the actively managed Fidelity Freedom Funds on the use of underlying Fidelity funds, so the expense ratio can vary. For example, annual fund operating expenses for Fidelity Freedom 2055 total 81 basis points, and that fund includes a higher allocation of underlying equity funds. Compare that with the 63-basis-point annual fund operating expenses for Fidelity Freedom 2015, which includes a higher allocation of underlying fixed-income funds.

While passive investing generally lowers target-date fund fees significantly, Stempien says, it does not do so automatically. A large plan could negotiate aggressively to obtain access to institutionally priced active funds or find actively managed collective investment trusts (CITs) with lower fees. Or a provider could charge a low investment fee for passive management but add a fee for glide path management, bumping up the overall fee total.

For plans with similar asset levels, fees apparently range little among passive target-date providers. “It is very competitive,” says John Ameriks, a Vanguard principal who leads its Investment Counseling & Research group. “It depends on what indexes are going to be involved. You usually are talking about plus or minus five to 10 basis points.”

2. The glide path becomes even more crucial. As Stempien says, going with passive management means the sponsor pulls out one of the main drivers of performance—the underlying managers. Ultimately, that makes the glide path and the sub-asset-class decisions—such as how much gets invested in growth versus value, small-cap versus large-cap and U.S. versus international—even more critical. “People may think, ‘This is passive, so this is a much safer investment,’” he says. “A fund provider determining that it will be passive versus active does not necessarily mean that the glide path will be more or less aggressive than its peers. A fund family may choose a very aggressive glide path and may choose to manage with index options.”

Without active management, the glide path and asset classes may largely determine overall volatility and risk, Cohen says. “Actually, there is no such thing as a passive target-date fund,” he says. “The glide path is going to be a much bigger determinant of absolute performance of the target-date fund than whether it is invested passively underneath.”

Using passive management in target-­date funds brings up an interesting question, says Roger Williams, a Darien, Connecticut-based senior vice president at Segal Rogerscasey. “Should the glide path be different than for an active program?” he says. “Theoretically, if you have less diversification [with indexing], the glide path should be a little more conservative.”

And using passive target-date funds changes nothing regarding sponsors’ need to analyze and monitor the glide path, Ameriks says. “When a plan sponsor is looking at target-date funds, they need to factor in all the same criteria,” agrees McHugh.

Sponsors still have to understand which glide path works best for their participants. “If you are a law firm and you have a defined benefit [DB] plan, you might feel comfortable having more risk,” Williams says. “If you are a retailer with many individuals with smaller balances and high turnover, you may want a program with less risk.”

3. Indexing makes monitoring simpler. Overseeing a plan has become a very complex process, and the desire for more simplicity is another reason that sponsors move to index strategies, says David Bauer, a partner at Casey, Quirk & Associates LLC, a Darien, Connecticut, management consultant working with investment-management companies. “They understand that their fiduciary responsibility is the same,” he says, “but the amount of work it takes to monitor an indexed target-date fund is perceived to be lower than if they have to keep monitoring 10 or 15 active funds.”

With active management, sponsors “are always faced with the questions: What happens if the management team changes? And what happens if there is a long stretch of underperformance?” Ameriks says. With passive funds, he adds, “a lot of management and oversight still needs to be done, but there probably are fewer steps. You still want to make sure that a manager is doing what it is supposed to be doing. But it is apparent immediately when there is an issue.” 

 

4. Education is still important­. Do not assume that indexing requires less participant education, though. “It probably does slightly reduce the complexity for the average investor,” Stempien says. “But at the end of the day, a target-date fund is still a very complex vehicle.”

A sponsor’s objective may be simplicity; however, the reality is, the vast majority of participants will still require plenty of education, Bauer agrees. “Most of them do not understand what a glide path is or the to-versus-through difference, and they do not understand the difference between indexed funds and actively managed funds.”

“I think it is the same,” says Randall Lowry, a TIAA-CREF managing director, regarding education about active or passive investments. “From a transparency standpoint, they need to understand what they are invested in.”

 

5. Pure indexing has some participant downsides. Going all-passive is “a tradeoff between the fees and the alpha,” Williams says. You may save with lower fees but you will also miss the opportunity to outperform the market.

Says Stempien, “Probably the biggest argument against going passive is the potential to lose out on the alpha opportunity. Research has shown that in certain asset classes, there is more opportunity to add alpha than [in] other asset classes.”

Those participants have the choice to utilize other plan investments, Ameriks says. “For people who say, ‘I want to do better than the rest of the market,’ that may be what the rest of the lineup is for,” he says.

And moving to all-indexed funds could mean missing out on some asset classes that could help diversify partic­ipants. “When you go to passive management, you cannot passively manage some asset classes—you either cannot do it or it is very expensive,” Cohen says. He cites as examples commodities, private real estate and high-yield debt. “If you dogmatically say, ‘No matter what, I am going passive’ in areas where there may be an opportunity to add 50 basis points a year with active management, you could be limiting participants’ ability to increase their retirement income and limiting their opportunity to invest in some interesting asset classes.”

6. A blended approach may be the answer. It is not an all-or-nothing decision. At the moment, more sponsors go either active or passive, rather than mixing the two approaches, Bauer says. But Casey, Quirk & Associates expects to see a blended approach used more often as defined benefit strategies continue migrating into defined contribution plans. “All the investment experience that plan sponsors and investment consultants and advisers have in DB asset allocation is, over time, migrating into target-date funds,” he says. “The early stages of target-date funds were driven by very big platform providers, who were all active managers. Then we had the financial crisis, and people realized, ‘We have taken a plain-vanilla approach to target-date strategies.’”

Russell Investments sees more interest now in a blend of active and passive management in defined contribution plans, Cohen says. “It is not all or nothing.”

In a world of fee and tracking-error sensitivities, Cohen understands sponsors’ interest in passive management. “But to give up on active management completely is probably a disservice to participants. If you solely go passive everywhere, there can be some opportunity cost,” he says. He mentions emerging-market equity, U.S. small-cap equity, commodities and listed infrastructure as examples. “Even 50 basis points a year, compounded over 40 years, can add seven additional years of spending in retirement,” he says.

“If you are trying to provide a good opportunity for participants to build a retirement nest egg,” Bauer says, “I do not think that a pure, relatively narrow indexed target-date fund is going to get people as far as a blended approach, with some opportunity for outperformance and somewhat broader asset classes.”


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