The Dow Jones Industrial Average lost 777 points on Sept. 29, 2008, and kept falling. It didn’t hit its low point until six months later. Investors in target-date funds near retirement lost over 22%, according to Morningstar. Those losses haven’t dulled investors’ appetites for TDFs over the ensuing 10 years, though. TDF assets have grown by double digits annually until, at the end of 2018, assets in TDF strategies exceeded $1.7 trillion, according to Morningstar’s “2019 Target-Date Fund Landscape: Simplifying the Complex” report.
What has changed is the type of TDFs investors want to put their money in. 2018 saw the first decline in assets in target-date mutual funds since 2008, Morningstar found, as investors opted for funds invested in low-cost index funds and CITs.
Morningstar was careful not to overstate the decline.
“In 2018, target-date mutual funds saw $55 billion in estimated net flows, down slightly from $70 billion in 2017, which was an all-time high. Yet, 2018 marked the 12th consecutive year these funds have hauled in at least $40 billion in inflows,” according to the report.
Price’s powerful influence
While assets flowed out of TDF mutual funds, TDF collective investment trusts started to see inflows. CITs represent a fraction of total TDF assets, according to Morningstar, but the report found price has a strong influence on fund flows.
Jeff Holt, director of multi-asset and alternative strategies at Morningstar, pointed to the increased focus on price as a primary driver for the interest in target-date CITs.
“Target-date funds with low expense ratios were seeing inflows and ones with higher expense ratios were seeing outflows generally,” he said of fund flows in 2018. “In conjunction with that focus on fees, there’s been increased demand for target-date CITs because those are often a lower-cost vehicle compared to the mutual funds [TDF] to get exposure to the basically the same strategy.”
The question plan sponsors, and by extension investors, may be asking themselves is why pay higher fees for what amounts to the same strategy?
In fact, according to Holt, ”many target-date providers … have become increasingly willing to launch multiple series, and oftentimes, they’re launching a lower-cost version of a series that they have run for many years.”
Morningstar found that when providers launch a low-cost series of an existing target-date fund, they typically adopt the same glide path used by their existing TDFs but select index funds rather than active funds as the underlying investments. It’s a strategy that, in terms of fund flows, has largely paid off for providers.
“Those providers that have launched a lower–cost version, in 2018, in all cases, the lower–cost version saw more inflows than the legacy version,” Holt said. That “massive gravitation or demand for low-cost target-date funds [is] really shaping the target-date landscape,” but he wonders if it’s the best thing for investors.
Morningstar analysts compared the Fidelity Freedom Index fund and the Fidelity Freedom fund, a higher cost legacy fund, and asked themselves, “would an investor have been better off had they moved to Fidelity Freedom Index, or would they be better off if they stayed in Fidelity Freedom?” Holt said. They found that on average, investors would have been better off with the legacy option, despite the higher cost.
Still, “it’s a case–by–case scenario,” he said. “There were several cases where the index series did a lot better than the legacy, higher-cost series, but it’s far from a guarantee that just by going with the lower–cost option, the investors are going to get better results.”
What really matters in TDF design
Price is hardly an indicator of how a fund will perform for an investor. ”What it really boils down to is two things,” Holt said.
First, “it’s the sub-asset class exposures. Some of the series that invest in index funds stick to the plain vanilla, broad asset classes, so they could be missing some areas like high–yield bonds or other things that that can drive returns.”
He added, “The other thing that makes a difference is the ability for the underlying active managers to add value to outperform their benchmark.”
He pointed out that investment managers who invest in target-date funds tend to favor those that are actively managed. Comparing series from providers that offer active, passive and hybrid or blended TDFs, Holt found “when you look at where they’re investing their own money, they’re putting it in the one that’s active in most cases. That’s where the conviction of the portfolio managers lies.”
Is there a professional bias there where people who manage money for a living have more respect for that active management than the average investor?
“There could be an element of that,” Holt said, “especially in cases where, if they’re investing in the active fund and those are their colleagues, they know them and they’re confident in them.”
But ultimately, he said, the point of a target-date fund is to offload the investment decision to a professional.
“Now that the professionals are offering, in some cases, multiple options, it’s interesting that investors might not be in the same series that the portfolio manager is investing their own money in.”
What’s new in glide path design
Glide path design is a relatively steady practice, with few providers making frequent changes to their glide paths, Holt said.
“Since 2008, the main trend has been, if a target a provider has switched their glide path, it’s usually increased equity exposure, but it’s a case-by-case basis. Most of the time providers aren’t switching those super frequently,” he said.
However, one thing analysts at Morningstar are seeing is increasing interest in foreign exposure in sub-asset classes.
“Over the last several years, we have seen an increase in the amount of foreign exposure in both the equities and the bond portfolios,” Holt noted.
The reasoning that some providers have offered is that they’re trying to increase diversification and reduce home country bias.
“Initially, a lot of target-date funds had a pretty heavy home country bias in equity portfolios even, and just to improve the diversification has been the main reason that’s been cited,” Holt said of providers’ increasing foreign exposure in TDFs.
However, he added that “a lot of the providers are reviewing their capital market assumptions regularly, and that factors into how they design their glide path. Being in a period where non-US equities have been relatively out of favor compared to US equities, that could play into the decision [that now is] a good time to get into the international side.”
Although most investors will see target-date funds as something they can elect once (or be defaulted into) and never think about again, Holt noted that sponsors need to look deeper at funds’ underlying investments. Morningstar compared target-date index series from Vanguard and State Street.
“If you just look at the strategic equity glide path, they look pretty similar,” he said, “but when you actually look down at the sub-asset classes, you’ll see some significant differences in their exposures.”
For example, the Vanguard series invests more heavily in foreign bonds, he said.
“Plan sponsors have to be mindful that there’s certainly more than a price tag that they’re buying when they select a target-date series.”
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
