The Independent Market Observer

What’s Trending in Target-Date Funds?

Posted by Michael Geraci, MSF, CRPC®, CRPS®, CPFA, AIF®, CIMA®

This entry was posted on Apr 21, 2021 2:55:50 PM

and tagged Commentary

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target date fundsToday's post is from Michael Geraci, supervisor, retirement consulting investment services.

Last year was a challenging one for the financial markets, resulting in volatility for most investment products. In fact, the coronavirus pandemic presented the biggest test for most asset allocation products since the 2008 financial crisis. 401(k) investments were no exception, specifically target-date funds.

But despite the drawdown seen in Q1 2020, the stock markets rallied to record highs by year-end, and target-date funds hit an all-time record of $2.8 trillion at the end of 2020. Net contributions, however, fell to $52 billion. Further, net inflows to target-date strategies fell by 59 percent in 2020 as the economic stress of the COVID-19 pandemic weighed on investors.

This stoppage in net inflows, despite strong returns, reveals the disconnect between the economy and the capital markets. Given this disconnect, it’s important to understand target-date funds’ strategic objectives and allocations to see how fund managers can navigate volatility in the equity markets. Let’s take a closer look at what’s trending in target-date funds, as well as lessons learned from the experiences of 2020.

The World of Low Fees

A major trend within the target-date asset category is the evolving downward pressure of the fee structure. Investors have supported this trend for almost a decade, preferring the least expensive share classes within target-date fund families. As with many other asset categories, asset flows follow fees, and investors have caught on to the preference for low fees. Indeed, a profusion of research shows cheaper funds tend to outperform more expensive ones. This movement to the cheapest share classes continues to lower the target-date mutual fund fees that investors pay.

A good ratio to assess what investors are actually paying for their funds is the asset-weighted target-date expense ratio, which dropped 7 bps in 2020 and is now half of what it was back in the financial crisis, according to data from Morningstar’s “2021 Target-Date Strategy Landscape” report. In 2020, the asset-weighted expense ratio fell for 28 of the 47 target-date series incepted before the year.

Passive Underlying Investments

Another trend in the target-date funds category is the use of passive underlying investments, which helps drive down costs. But, of course, there is an active decision-making process at play in the asset allocation of the fund series. One way some of the index target-date managers lower costs is by making it easier for 401(k) plans to access their cheaper share classes. Some of the largest asset managers (e.g., Vanguard and Fidelity) do so by lowering thresholds on their institutional share classes. When analyzing target-date funds, you will find that fee differences are scarcely falling and return differences are falling significantly. As such, it would seem fees have become the better predictor of performance.

The Blend Series

Over the past decade, investors and 401(k) participants have demanded cheaper options in the target-date space. Asset managers who were primarily invested in actively managed funds responded by launching a passively managed or “blend” series, a mixture of both passively and actively managed underlying funds. Overall, there is not a strong winner when choosing between an asset manager’s actively managed series and a passive series when the glide path and asset allocation are similar. But if we look at more than just fees, an active manager should be providing a lower portfolio risk, higher downside protection, and alpha generation as a means to its larger fee.

The choice does not have to be strictly between actively managed funds or passively managed funds. As previously mentioned, blended target-date funds have gained traction recently as investors look for ways to cut costs while still having conviction in active management. In 2020, 3 of the top 10 target-date mutual fund series ranked by inflows were blended strategies. When categorizing blend series, Morningstar considers series between 70 percent and 30 percent active exposure as a 2030 portfolio. The blend series trend has emerged because most actively managed equity funds struggle to add value net of fees, and most active fixed income funds often lag their prospective benchmarks. Due to the lack of long-term active U.S. large-cap managers, most of these series use a U.S. large-cap index with an active intermediate core bond manager within their allocations. This strategy leads to the outperformance of their blended benchmarks while keeping the overall series costs low.

So, What Have We Learned?

When we look back over the past year, the uncertainty that was priced into the capital markets, along with the volatility at the beginning of 2020, comes to the fore. But for target-date funds, 2020 was a standout performance year. Most target-date series were flexible enough to absorb the first-quarter’s drawdown while still holding enough equities for the portfolios to rebound by year-end.

Within target-date funds, equity holdings tend to drive performance, and the fixed income allocation can help drive a strategy’s performance during capital market drawdowns. Underlying portfolio allocations were important, as were the opportunities to rebalance portfolios during the sell-off. Further, managers had to be flexible enough to take a tactical overweight in periods where investment opportunities presented themselves.

One of the main takeaways of 2020 target-date performance has been the value of risk management in limiting losses through diversification. Target-date funds are designed to give the investor a well-diversified portfolio that can help withstand the ups and downs of the markets and provide a smoother ride to retirement. 2020 was a marque year to highlight some recent developments in the target-date fund world.

Investments in target-date funds are subject to the risks of their underlying holdings. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative investments based on its respective target date. The performance of an investment in a target-date fund is not guaranteed at any time, including on or after the target date.

Basis points (bps) is a common unit of measure for percentages in finance. One basis point is equal to 1/100th of 1 percent, or 0.01 percent.

Alpha is a measurement of the performance of an investment as compared to an index such as the S&P 500. It is considered to be an investment’s active return and is used to understand how an investment is performing as compared to the market as a whole.

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Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

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One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

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