This has had a significant impact on plan sponsors, advisers, and consultants in their roles as fiduciaries. In particular, the new standards have come with increased pressure to ensure management fees are reasonable in light of the services actually being provided by an investment manager. While it may seem daunting at times, plan sponsors should recognize the role they play in the target-date due diligence process, and quickly get up to speed from an evaluation standpoint as a named fiduciary of a plan.
An important consideration when assessing whether a target-date fund fee is reasonable, is whether or not a target-date fund is actively or passively managed. In theory, it is not difficult to distinguish between active managers and passive managers. An active manager will typically make investment decisions based on current fundamentals and valuations, as well as maintain the flexibility to adapt and manage risks based on evolving market conditions. In contrast, a passive manager will simply link portfolio construction to a benchmark, essentially mirroring a market index, and rebalance back to a preset allocation glide path.
In practice, however, it can be difficult to determine exactly how active a manager really is. The challenge is often compounded in the defined contribution industry because many target-date funds are constructed as a fund-of-funds. Often, when displaying a target-date fund’s composition, the investment manager may simply list the underlying mutual funds or exchange-traded funds (ETFs), rather than provide a detailed list of individual holdings within the constituent funds. Without a more detailed description of the securities that make up these underlying funds, it is difficult, if not impossible, to know how active an actively managed target-date fund is.
How can an actively managed target-date fund become a passive fund? The answer is over-diversification. Specifically, a target-date product could come to resemble a market index because lack of coordination between portfolio managers may result in holding too many individual securities. This would make it difficult for plan participants that invest in the target-date fund to experience returns that are materially different from the benchmark. Over-diversification should be on a plan fiduciary’s radar because it may result in paying active management fees for what ultimately is passive investment positioning and risk management.
Fortunately, tools are available to help plan fiduciaries measure the extent to which lifecycle funds are actively managed. This, in turn, can assist in determining whether participants are really getting what they pay for when they choose to invest in target-date products.
One tool plan fiduciaries can use to analyze the equity portions of target-date funds is active share. The concept of active share was developed by two professors in Yale’s School of Management, and was presented in a study originally published in 2006, and again in 2009. Active share measures the percentage of a fund’s weight-adjusted portfolio that differs from the benchmark. Readings fall within a possible range of 0% to 100%. Very simply, the higher the active share, the higher the level of differentiation between the portfolio and its benchmark.
In addition to quantifying the extent to which a portfolio’s holdings differ from a benchmark, the fact that active share information is current is another distinct advantage. Other tools often use backward-looking data, and may be less useful to fiduciaries that need to focus on determining how effective they believe a product will be at helping plan participants achieve their financial goals going forward.
While a high active share number is not a guarantee of future excess returns, the premise of active share remains relevant for target-date portfolios. Specifically, we should not expect an active manager to add value unless the manager has the flexibility to look different than the benchmark. It is also necessary to keep in mind that it is not a catch-all, but rather one of many tools that can and should be used by fiduciaries such as plan sponsors when performing their target-date due diligence. A timely measure, given the challenges posed by today’s low yield environment on the Treasury-heavy U.S. bond market, is the sector exposures and maturity structure of the fixed income holdings relative to an overall bond market index. In addition, several other metrics may be considered, including historical performance draw down and recovery in turbulent markets, and up/down capture ratios.
Ultimately, participant objectives should always be the driving force behind the selection and monitoring of lifecycle funds. In order to view target-date fund selection and monitoring through a fiduciary lens, target-date funds need to have the transparency necessary to allow plan sponsors to evaluate such issues as fee flexibility, risk management, and the ability of the funds to meet participant goals and objectives.
More information about target-date fund transparency can be found in our recent whitepaper, issued with Strategic Insight, an Asset International company, at www.manning-napier.com/raisethebar.
Jeffrey S. Coons, PhD, CFA, president and co-director of research at Manning & Napier
This summary is for informational purposes only and does not constitute an offer.
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