More DC plan sponsors are using target date funds that blend active and passive strategies to seek lower fees and enhanced alpha potential, according to a new white paper.
While these strategies typically have garnered limited attention due to limited product offerings, that appears to be changing, PIMCO explains in “Target Date Funds: Blend Is the Trend.”
“Blend TDF assets have grown nearly five-fold since 2013 as the number of offerings has doubled, with many fully active or fully passive TDF asset managers introducing a blended (or hybrid) fund, each slightly different from the others,” PIMCO authors Erin Browne, Bransby Whitton and Georgi Popov write.
Active TDFs dominated initially, capturing over 90% of the market in the early 2000s. But passive TDFs have been gaining momentum, surpassing active TDFs in market share three years ago, the paper notes. Additionally, this trend “does not appear to have been driven by disappointment” in active management performance, but rather by factors such as fees and litigation risk, the authors contend. “In our view, the pendulum has swung too far from active to passive,” they write, “and a compromise that incorporates investment considerations may be warranted.”
Benefits of Blend
Citing the benefits of blend TDFs, they note that such strategies typically carry lower fees than fully active options. In addition, the authors emphasize that blend TDFs offer alpha potential from active management, which – typically for a modest fee premium – may result in higher income-replacement ratios or improved longevity of assets in retirement versus a fully passive TDF. Some alpha potential may be lost, however, due to the lower-fee passive component, the paper further observes.
The paper goes on to explain that, when plan sponsors and advisors select individual funds for the DC core menu, more than half the time they are blending active and passive funds, adding that blend TDFs bring a similar philosophy to the QDIA space.
The authors further point to PIMCO’s 2019 Defined Contribution Consulting Study, noting that nearly half of consultants and advisors recommend packaged active/passive (blend) TDFs for plans below $1 billion. Additionally, most consultants rank highly the importance of going active in fixed income. “The consultants surveyed believe that active management is extremely important or very important for both U.S. bonds (88%) and non-U.S. bonds (82%), the two largest fixed income sectors across the TDF industry’s bond exposure,” the paper states.
When evaluating the spectrum of blends, the authors explain that there are certain objectives to consider, including optimizing the mix of active and passive underlying funds based on cost-benefit analysis.
They note that this is the same process that consultants and advisors use to select the core menu lineup and is similar to how plans above $1 billion design custom TDFs by determining where there’s value in going active and where to use passive to keep costs low. On DC core menus, they note that the ratio of active-to-passive fixed-income offerings is 2 to 1, while active-to-passive equity is 1 to 2.
The authors further emphasize the importance of deciding which managers are best in class in the underlying offerings and recognizing that few active managers are “equally adept” at managing equities and fixed income.
