‘Low-Cost’ Does Not Always Mean ‘Better’ TDFs
Morningstar warns that the distinction between "active" and "passive" target-date series has become more muddled in recent years.
All-time high flows, paired with positive returns, lifted assets in target-date funds (TDFs) above $1 trillion in 2017, a sizable increase from just $158 billion at year-end 2008, according to Morningstar’s 2018 Target-Date Fund Landscape report.
The report says many TDF providers have adapted to meet the burgeoning demand for low-cost options.
In 2017, passive TDF series—ones that invest predominantly in index funds—attracted nearly 95% of the $70 billion in estimated net flows to TDFs. This preference appears to be driven by retirement plan sponsors’ demand for low costs, Morningstar says.
Fees for TDFs continued their multiyear downward trend in 2017. The average asset-weighted expense ratio fell to 0.66% at the end of 2017, from 0.91% just five years earlier. Morningstar says the injection of more passive exposure within historically active target-date series and the launch of series that blend active and passive funds has contributed to that trend.
When TDF providers have launched additional lower-cost series to meet demand, those series generally have been the most popular. However, Morningstar finds not all have produced better performance results than older, more-costly ones.
Not only do TDF providers offer variations of their strategies, they also commonly make their strategies available in a different vehicle, via a collective investment trust (CIT). CITs, which are designed for qualified institutional investors, typically cost less than mutual funds.
Low costs allow investors to reap more of their investment gains, but investors in TDFs need to look beyond price tags to investment strategy to determine the appropriateness of the fees. Morningstar warns that the distinction between “active” and “passive” target-date series has become more muddled in recent years. Several target-date series that have historically held actively managed strategies have inserted or relied more heavily on passive funds. Meanwhile, other series explicitly aim to blend active and passive funds. “Some target-date series may appear competitively priced on the surface, but less so when considering their passive exposure,” the Morningstar report says.
Before drawing conclusions about the performance rankings of various TDFs, investors should be mindful of the relatively tight dispersion of returns within TDF categories, Morningstar also warns. Despite TDFs’ significant exposure to equities, their return dispersion is more like the intermediate-term bond category than the U.S. large-blend category. According to the report, excluding major outliers, the 2050 TDF category saw returns range from 17.4% to 24.0% in 2017, and that 6.6 percentage point dispersion in returns was much tighter than the U.S. large-blend’s 20.5 percentage points and even tighter than the intermediate-term bond’s 8.8 percentage points.
While still not a majority, the S&P Target-Date Indexes have emerged as the most popular benchmark among TDF providers, with 24 of 60 series listing them as the primary benchmark. Single asset-class benchmarks, such as the S&P 500, tied for second with custom indexes, and while they may be effective in some instances, they are difficult for the end investor to use as a yardstick, Morningstar says. Plus, custom indexes vary by target-date series depending on the asset-allocation approach, and they rely on the TDF provider to build the benchmark judiciously.
The report highlights noteworthy considerations for TDF investors in five areas: Price, Performance, Parent, People, and Process. The report may be request here.
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