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Passive Shift Leaves Mark on TDFs

Target-date mutual funds saw another year of strong flows in 2016, though not quite as strong as seen in 2015 – and 3 of the 10 largest target-date managers experienced outflows for the year.

According to Morningstar’s 2017 Target-Date Landscape report, while Vanguard and American Funds both saw exceptionally strong flows in 2016, Fidelity, which remained the second largest target-date manager, saw nearly $3 billion in estimated outflows in 2016 (the third consecutive year of outflows for the firm). Principal and John Hancock also experienced estimated outflows from their target-date mutual funds. Wells Fargo's nearly $7 billion in estimated outflows was the largest in 2016, although it was largely attributed to moving a large client to a collective investment trust version of the strategy, according to the report.

That said, growth hasn’t been equal. Vanguard's $37 billion in estimated inflows in 2016 represented more than half of flows to target-date mutual funds in general, and that contributed significantly to the aforementioned trend of passive series seeing more flows than active ones. American Funds’ $16 billion represented a (distant) second with nearly $16 billion in flows. Aside from these two firms, T. Rowe Price was the only other one that saw at least $5 billion in estimated inflows.

On average, the 10 largest target-date managers have 16% of their assets under management in target-date funds. The “big three” – Vanguard (31.8%), Fidelity (21.9%) and T. Rowe Price (16.8%) – continued to hold the lion's share of TDF assets. All told, the inflows, coupled with the funds’ generally positive returns, lifted assets to an all-time high of more than $880 billion by the end of 2016. In 2016, passive series saw more than $40 billion in estimated inflows compared with $23 billion for active ones – roughly two of every three dollars went to a passive series.

Passive Progress

Indeed, according to the analysis over the past couple of years, target-date series that invest exclusively in index funds have seen significantly more flows than those that use actively managed underlying funds. As a result, the market share of active and passive series has converged. (The author notes that no target-date series is truly passively managed, as every target-date manager makes active decisions in building a glide path and selecting asset classes.)

However, active series generally attracted more flows until 2012, when passive series saw slightly higher inflows. Only in the past couple of years have passive series had a sizable advantage (in 2007, active series reaped more than $40 billion in estimated inflows, while passive series only saw $16 billion in estimated inflows). At the end of 2006, active series held 83% of TDF assets, but by the end of 2016 they only accounted for 61% of assets.

Morningstar noted that while the average sub-asset-class glide path for active target-date series and passive ones do not differ significantly, the average passive series tends to hold less in high-yield bonds and Treasury Inflation-Protected Securities (TIPS) than its active counterpart.

Expense Sieve?

The average asset-weighted expense ratio fell to 0.71% by the end of 2016, a notable decrease from 0.99% just five years earlier. The report notes that fees may not be a strong predictor of future performance for target-date funds, but they are a strong predictor of survivorship. Morningstar also notes that differences in asset allocation can offset a fee advantage; over the past seven years, a 1-percentage-point increase in equity exposure resulted in a 6-basis-point annualized improvement in performance.

The average equity glide path hasn’t changed dramatically in recent years, particularly for the youngest and oldest investors. However, the report notes that midcareer investors have seen a modest increase in equity exposure. Many target-date series still stand out far from the consensus, and the dispersion is greatest for target-date funds nearing their target date. Additionally, Morningstar observes that alternatives have not gained much traction within TDFs, likely because of the high costs associated with them.

Despite difficulties in gaining traction, asset managers continued to explore ways to participate in the growth of TDFs. At the end of 2016, 12 firms offered more than one target-date series in an attempt to cater to different investor preferences. Ten years ago, no firm offered more than one.