Thoughts on Morningstar's Target Date Fund Research

Two weeks ago Morningstar published its 2010 Target Date Fund Survey. In the survey Morningstar compared the performance of “open” and “closed” fund series and drew the conclusion that neither had a distinct performance advantage. This conclusion is not particularly surprising given relatively few funds have long enough return histories to do a complete analysis. However, what was surprising was what Morningstar omitted from the report, and in particular three major differences between “open” and “closed” funds that we think paint a very clear picture of why the differences between open and closed funds are significant. Before we dive into these three major differences, let us first briefly touch on why this issue is important.

Conflicts in Target Date Funds: Open vs. Closed Architecture

One of the largest recurring issues in the target date marketplace is the presence of conflicts in “closed” target date fund management, in which a single manager controls the glide path and manages the underlying investments. Our recent study entitled “Real Facts about Target Date Funds” made the point that closed target date fund series have conflicts of interest, insofar as the manager has an incentive to take on more risk and allocate more heavily to more lucrative, higher-cost investments. There are at least two solutions to this problem. One is requiring all target date fund managers to be fiduciaries. The other is separating glide path creation and fund selection from investment management. There are several fund families that have taken this “open” approach. Comparing the performance differences between open and closed funds is likely going to be a significant battlefield over the next few years, and Morningstar is in a unique position to weigh in on the issue.

So Which One is Better: Open or Closed?

With only a few years worth of performance data, it remains to be seen whether the conflicts in target date funds will lead to concrete performance or design differences between “open” funds and “closed”  funds. Morningstar looked at the data for target date funds and tried to determine whether or not open series had a demonstrable return advantage. They concluded that there is no difference. Or at least not yet. I have some qualms with their methodology of simply sorting all target date funds by returns and counting how many open funds are in the top 10 and bottom 10 in order to determine which version is winning. But, putting that methodology discussion off for another day, when you move away from the “sort and count” approach and actually look at the averages for open and closed funds, three data points literally jump off the page:

1. Closed Target Date Funds have more Aggressive Glide Paths: In theory, the major drawback of closed architecture funds is that the managers have an incentive to ratchet up the risk in their glide paths so that more money is allocated to funds with higher fees. If this hypothesis is actually borne out by the data, then it is actually rather arbitrary to compare performance. The more aggressive closed funds would outperform in bull markets and the more conservative open funds would outperform in bear markets. But does this difference actually exist in the Morningstar data? As it turns out, it not only exists, but is significant: 2010 target date funds with open architecture had an average equity allocation of 36.6%, while 2010 funds with closed architecture had an average equity allocation of 49.1%.

This is a very significant difference in risk between funds of the two types. Target Date managers with closed architecture are taking much larger risks and allocating more money to equities than their open architecture brethren. This strategy did not benefit investors who were counting on that money to retire only to find they lost 40% of their assets in the 2008 downturn. But, this difference is in line with the incentives target date fund managers have to create aggressive glide paths and bloated equity allocations in order to increase investment management revenue. While a single data point is not conclusive as evidence of a conflict, we honestly did not expect the gap to be as large as it is and believe that it warrants additional research.

2. Closed Target Date Funds Use Almost All Active Management in All Asset Classes

The second major way a conflict in target date funds might manifest itself in the data is increased use of higher cost active management funds. We compared the use of active management by closed managers and open managers in the Morningstar data. In total, 12 of the 17 (70%) closed architecture series included in the report invested 100% of its assets in actively-managed funds, compared to only 1 of 7 (14%) open architecture series.  The average active allocation for closed architecture series is roughly 90%. However, if you exclude Vanguard this number jumps to over 96%. In comparison, the average active allocation for open architecture series is 49%.

This data point is even more conclusive than the previous one: closed managers are far more likely to use active management in all asset classes than are open managers. The difference in allocation to actively-managed funds is particularly important when you consider Morningstar’s own conclusion that “Management subtracts from returns” (22).

3. Closed Funds Exhibit Worse Fund Selection Capabilities.

In their performance attribution analysis, Morningstar determined that fund selection was a detractor for 23 of the 32 series. So, in general it doesn’t appear that target date fund managers can consistently add value through fund selection. However, the more interesting data point is that the average performance attribution of open funds was -0.64% compared to -1.77% for closed funds – so while both are subtracting value, closed funds are subtracting an additional 1% a year from returns.  Fiduciaries and investors should track this performance gap closely. Losing 1% in performance over a 30-40 year period can have a major impact on retirement outcomes. I think researching why this gap exists is a critical next step, and in particular identifying if the gap is related to 1-2 above.

Conclusion

The three bullet points above show stark differences between open and closed target date fund management. Due to these differences, there will be meaningful performance differences in the future. Fiduciaries need to be doing more to analyze their target date funds and in light of this data should consider whether the fund is open or closed. This is particularly relevant right now because the overwhelming majority of target date fund assets are currently in closed funds:

Disclosure: We have ongoing dialogue with John Rekenthaler, Morningstar’s VP of research. Their team is very good with data and John made it clear that they will take another look to see if anything jumps out at them. I am confident that when they do take another look they will be just as interested in the data as we are. I look forward to reading the conclusions they make, if any.

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