A new report looks at target-date funds – the impact of market timing, their glide paths, their affinity for “family” funds and how their performance stacks up against a do-it-yourself approach.
The report, “Target Date Funds: What’s Under the Hood?” is based on analysis using Morningstar data for the period 2004-2012, data on about 1,100 TDFs from 50 fund families. However, the report was based on a sample that uses only one dated fund – either 2035 or 2030 – from each family.
The report notes that the typical TDF invests in 17 funds on average and includes holdings like emerging markets, real estate and commodities, and that the prevalence of these specialized assets has increased over time.
Alpha Bet?
After a brief discussion of TDF history, basics, TDF investments, structures and how that affects fees, the report examines the performance of TDFs. The report stipulates that the alpha for a TDF is a weighted average of its underlying funds, and finds that the average alpha for the TDFs in the sample is -20 basis points per year, which the authors say is statistically significant.
However, they note that while that return reflects the fees on the underlying funds, it does not account for the overlay fee added by the TDF. When this fee is added – roughly 50 basis points on average – the total alpha is roughly -70 basis points, which the authors say approximates the average alpha for mutual funds in general. So the authors conclude that overall, TDFs fall short of their benchmark indices but perform about the same as all other mutual funds.
Glide Pat?
Turning to the potential impact of market timing, the report notes that despite their established glide paths, TDFs “often deviate from their path to try to improve returns by responding to changing market conditions.” The paper claims that when compared to strictly following the glide path, the average return due to market timing across all funds is -11.5 basis points per year; and when the returns are weighted toward funds with a longer track record, the result is -14.1 basis points. “In short, deviations from the glide path do not improve, and may even hurt, performance,” according to the report.
‘Family’ Matters
The report cites what it calls a “body of research” that they say suggests that fund managers tend to make investment decisions that help fund family objectives at the expense of lower returns for shareholders. The authors note that TDFs in general are useful for studying potential bias toward fund family objectives because they (at least in their sampling) primarily hold funds from within their own family. They note that in their sample, 70% of the funds that were added to a TDF during the period studied had at least one alternative fund in the family with the same Morningstar classification. Performing an analysis that uses these alternative funds as the point of comparison, the authors find that three types of fund family objectives can adversely affect TDF returns, specifically that:
- TDF managers tended to favor start-up funds, which had substantially lower returns over the next three years than the alternatives within their fund family.
- Some managers tilted toward high-fee funds, which had a lower subsequent performance than the alternatives (though they note that this difference was not statistically significant).
- Managers favored smaller funds, perhaps to help them grow to a profitable size. (The authors note that the subsequent performance of these smaller funds was much lower than the alternatives.)
In summary, the authors conclude that:
- TDFs, on average, perform roughly the same as other mutual funds.
- When managers veer from the glide path, it doesn’t help, and may hurt, performance.
- Fund family objectives can lead to fund additions that hurt returns.
