Paper Says Target-Date Funds “Structurally Unsound”

April 9, 2013 (PLANSPONSOR.com) - Though a worthy idea, the target-date (TD) fund concept appears to have been implemented hastily and poorly, a paper asserts.

In the paper, “Target Date Funds: Structurally Unsound,” Marc Fandetti with Meketa Investment Group says, “The presence of serious structural flaws in the current generation of TD mutual funds suggests that most but not all such funds should be avoided by plan sponsors and investors, or at the very least used with extreme caution.” Fandetti argues that TD funds are expensive due to heavy reliance on active equity managers, and as such are priced (and behave) like actively-managed equity funds, and, actively-managed TD funds likely cannot, on average, add alpha over time.  

“TD fund excess return (positive or negative, relative to a benchmark) can result from asset allocation decisions, underlying manager decisions (both security selection and varying asset class or ‘beta’ exposure), or both. It is difficult for all but the most sophisticated plan sponsors and advisers to conduct rigorous enough performance attribution to truly get to the bottom of realized returns. And if such analysis is beyond the capability of many plan sponsors, it is almost certainly not possible for the vast majority of plan participants. In this sense, TD funds are opaque,” the paper says.   

Fandetti advises that plan sponsor should understand the causes of under or overperformance relative to the TD fund manager’s chosen benchmark. If, for example, a TD fund manager’s over- or underperformance is attributable to asset allocation and not manager performance, the plan sponsor may want to look for similarly allocated TD funds that are less (or not at all) reliant on active management.  

When speaking about TD funds’ glide paths, Fandetti argues that “to quibble today about asset allocation decades hence is probably a distraction,” and “[c]urrent risk should probably weight (far) more heavily in plan sponsor or participant TD fund decision-making.”  

The paper can be downloaded from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2243185.

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