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Target-Date Funds Get Cheaper, Use Tactical Allocation Well

Morningstar's annual industry study points to Fidelity as the new price leader, replacing Vanguard.

Morningstar's annual study of the target-date industry, out today, shows these retirement funds continue to get cheaper while garnering stronger performance in unexpected ways. The industry, which turned 20 years old in 2014 and captures most new dollars into retirement plans, consistently has pushed fees lower: For the fifth year in a row since Morningstar's first annual target-date survey, the industry's average asset-weighted fee has come down. It stood at 0.84% at the end of 2013, down from 1.04% in 2008.

Part of that movement comes from a longer-term trend favoring lower-priced index-based investments within target-date funds. The Fidelity Freedom Index series, for instance, now holds the mantle of lowest-priced series with its 0.16% asset-weighted fee, replacing Vanguard--with its 0.17% asset-weighted average expense ratio--as the cost leader.

Target-date series that primarily use actively managed strategies and funds have been systematically lowering their fees as well. Expenses shouldn't be investors' sole consideration when picking funds, target-date or otherwise, but lower fees give investors a head start and are money in their pockets.


 

Target-date series' portfolio managers, on the other hand, control target-date funds' performance using a wider variety of tools, and some have been more effective than others. Certain target-date fund managers, for example, offer open-architecture series that feature asset managers from a variety of firms. Theoretically, this gives them access to best-of-breed managers regardless of fund-company affiliation.

And yet, those series have so far failed to live up to their potential--they've delivered results similar to series that feature underlying in-house funds. The three industry leaders by assets--Fidelity, T. Rowe Price, and Vanguard--all feature closed-architecture target-date funds. Both types of target-date series have average overall Morningstar Ratings of 2.7 stars across their vintages. Morningstar's figures suggest that open-architecture funds on average provide a performance advantage before fees, but the higher costs needed to gain access to those strategies have generally negated those gains.

Meanwhile, target-date managers that have the flexibility to make shorter-term tactical adjustments to their target-date funds' longer-term asset-allocation glide path have shown an edge over competitors that stick closely to their strategic asset-allocation plans. Tactical management has intuitive appeal since it allows managers to attempt to avoid frothy areas of the market or jump into asset classes that appear poised for a rebound. And while academic and industry research have shown it's difficult to consistently make additive market-timing calls, so far, many target-date managers with tactical leeway have delivered strong results relative to peers.

Managers can use open-architecture underlying funds or tactical asset-allocation shifts to differentiate their target-date funds from the pack. Other standout techniques include ceasing asset-allocation shifts at retirement, a structure known in the industry as a "to" glide path. Other series continue to move away from stocks into less-volatile investments, like bonds and cash, after investors' retirement date (known in the industry as a "through" glide path). Those points of distinction may hold the key to providers angling to gain market share from Fidelity, Vanguard, and T. Rowe Price. Collectively, those three firms hold roughly three fourths of the industry's target-date mutual fund assets, largely because of their dominant defined-contribution record-keeping businesses.

Of course, gaining new assets, at least in the target-date realm, hasn't been a zero-sum game. The overall target-date market saw a 10.5% organic growth rate in 2013, and target-date managers, large and small alike, have generally continued to see healthy growth from those funds. In all, the industry took in more than $50 billion in new flows in 2013. Combined with an additional $18 billion in new assets in 2014's first quarter plus market appreciation, target-date mutual funds now hold more than $650 billion in assets.

In fact, for a number of target-date series, new assets into target-date funds have been a very important source for their respective fund companies' mutual fund net flows. T. Rowe Price stands as one of the more extreme examples: Its target-date series gained more than $8.1 billion in net new assets in 2013, representing more than 90% of the firm's total $8.5 billion in net new mutual fund assets that year (excluding money market flows). In aggregate, new monies into target-date funds represented almost a third of firms' 2013 net flows.

Those figures underscore not only how ubiquitous target-date funds have become to individuals saving for retirement, but also their central role to many fund companies' business prospects. With echo boomers--a group often anecdotally noted for embracing the set-it-and-forget-it nature of target-date funds--beginning to enter their peak earning period, investors and industry watchers should expect those numbers to continue growing in the years to come.