Evaluating Target Date Funds: Part 3 By: Gabriel PotterMBA, AIFA® 2014.07.30

Tools and techniques for evaluating target date funds

Now that you understand the considerations when evaluation target date funds, you may be wondering how to apply these factors to your own analysis and selection of investment choices.  We would like to conclude this article with some practical, actionable advice that you or your advisor can use to evaluate a target date fund series. 

Until now, we have tended to avoid identifying specific investment managers; instead, we have referred to a manager generically as “Manager A” to provide an example for our readers.  However, since we are now attempting to provide practical advice and next-steps, we will identify some investment managers and service providers by name.  Ideally, we would have provided direct web links to tools and whitepapers, but some resources are only accessible for registered users or financial advisors.  We hope engaged readers, if they are interested in expanding their knowledge of the target date fund universe, will register for access to the specific tools and resources that seem most useful. 

Screen a single vintage

One approach for evaluating a target date series is to begin its analysis as if it were a traditional investment.  As a reminder, a traditional screening for an investment - say, a large cap US growth fund - starts by comparing an investment to peers in its category on a variety of quantitative metrics including risk, return, expense ratio, turnover, and so on.  Similarly, a plan sponsor or consultant can pick a date in the middle of the glide-path, and run a traditional screen on products within the category.  For example, you could run a screen to find the best performing candidates within the 2030 target date category.

Every distinguishing characteristic and style bias that we’ve discussed thus far will impact the relative metrics of the funds in the screen.  The funds with an aggressive glide path (i.e. higher in equities for any particular vintage) will likely outperform if the screen is conducted during an extended up-market rally.  The funds which embrace alternative investments like commodities may outperform during high inflation environments.  If you run your screen during an extended market decline, your best-performing candidates might all be defensive “to-retirement” funds.  In other words, an investment screening might generate a list of candidates with similar attributes based upon the current market environment.  

Savvy investors should pay attention to this bias and adjust their screen to compensate.  They could incorporate out-of-favor candidates into a candidate list for the sake of diversity and a genuine selection.  Picking a target date fund, or any investment, based upon recent outperformance may be a recipe for disappointment.  The investment style in favor today may actually be less likely to outperform in the near future.  The investment adage “don’t chase the hot dot” is a warning against making an investment selection based on what is doing well today, since styles rotate in and out of favor.  Target date funds are intended to provide long term solutions that are robust over time and through multiple market cycles. 

Selecting a target date fund is a multi-faceted process.  A simple investment screen can be a useful starting point.  It will narrow a candidate list, but it should also identify which investment styles are in favor due to current market conditions.  However, a simple investment screen over a single target date category should not be regarded as a comprehensive, prudent process by itself.

Access to due diligence

If you, as a retirement plan sponsor, have relationships with consultants or service providers, you may already be paying for information.  Use it!  Wirehouses and broker dealers often direct their research teams to conduct due diligence on target date series, like any other investment product, and to share results with their clients.   Registered investment advisors often create their own due diligence reports to share with their clients.  Information service providers, like Morningstar, also provide due diligence reviews on investments, including target date series; these reviews can either be purchased through a license or subscription to the service.

Investment manager tools

Some investment managers have provided tools to assist with target date fund comparison.  One popular tool for advisors is the JP Morgan Target Date Compass, which places the competing target date series on a grid based upon two criteria:  first, the amount of equity at the retirement date and second, the diversity of assets within the series.  To assist with the process, JP Morgan provides a questionnaire for plan sponsors regarding their participants.  The results of the questionnaire can steer the plan sponsor towards target date funds which are most attractive based upon those two criteria.

Allianz Global Investors Target Date Tool Set also exists to assist advisors select a target date series.  Their tool has an inventive spin.  The target date universe is less mature than other asset classes and there are a variety of competing benchmarks, including the Dow Jones target date benchmarks, the S&P target date benchmarks, Morningstar equal-weighted, Morningstar asset-weighted, and so on.  The innovative aspect to Allianz’s tool is that it compares the relative performance of a target date series to a variety of benchmarks used by the target date industry determining which benchmark correlates most closely and is therefore the best comparison of performance.

These tools usually focus on mutual funds as the primary vehicle for investment comparisons.  However, 401(k)s and other defined contribution plans can use a target date fund investment through different vehicles, like a Collective Investment Trust (CIT) or separate account, but such vehicles are more difficult to compare than the relatively transparent mutual fund vehicle.

Collective trusts are co-mingled investment pools – like mutual funds – but they are often specific to individual recordkeepers, banks, or trust companies. Collective trusts are only available to ERISA qualified plans (i.e. individuals and government plans cannot use them).  The key advantage for a CIT is that it is often less expensive than a comparable mutual fund.  The key disadvantage is that CITs are harder to compare against peers - a necessity for determining prudence.  Also, CITs are often bundled into recordkeeping and custodial relationships, making them less portable.  Plan sponsors (and their advisors) trying to demonstrate prudence with peer comparison should know that Principal Financial Group is in the process of developing a new tool for evaluating CITs and mutual funds. Investment managers have recognized the need to provide guidance on target date series, and more tools and information sources are becoming available every day. 

Investment manager information

While an investment manager could never create a proper due diligence report on their own, due to the obvious conflict of interest, they often create their own research and whitepapers.  For example, Blackrock has rolled out information, tools, and training resources called the Blackrock target date edge program on their website.  Naturally, any research created by an investment manager should be read with a critical eye, but their information can still be helpful. 

For another example, Russell Investment’s research department put out an interesting whitepaper – “Evaluating target date investment performance”.  They separate the relative performance of a target date series into the underlying, separate components (glide path, tactical positioning, asset allocation, etc.) by comparing actual returns to benchmarks of differing complexity.  The methods espoused in this whitepaper, while useful for analyzing the relative performance of Russell’s product, is equally useful for evaluating competitors.

Truthfully, the investment managers are generating so much information that nobody could keep up with it all.  During the week we spent fine-tuning this article, we have been invited to web seminars (e.g. Principal’s “Use the DOL tips on target date as your key differentiator”) and received whitepapers (e.g. Manning & Napier’s “Raising the bar on target date due diligence”, ING’s “Rethinking glide path design – a holistic approach”) on this very topic.  Despite our expectation that their information is a thinly disguised sales-pitch, we can parse and separate the facts from the public relations spin.  We appreciate the additional perspective, even if the time to properly digest all of it is limited.  The tools and research from investment managers may be biased, but the information is usually credible and verifiable. 

Tailor your choice to the current market environment

In the long term, the strategic allocation of a target date fund – or any balanced investment – will be the primary determinant of relative performance.  However, just as some funds tactically adjust their underlying allocations in response to the market environment, there is a potential advantage to selecting a target date series that might be positioned to outperform in the projected market environment.  Investors prefer to start an investment with a favorable tailwind as early gains and contributions compound over time.

Keep in mind that sales professionals will be eager to describe how their investment products are timely and well-positioned.  In the past month, PlanSponsor and Russell Investments teamed up for a recent seminar, “Evaluating your plan’s target date funds in light of today’s volatile markets”.  Their emphasis was on which product characteristics should be advantageous given the current market environment (i.e. low interest rates, following a 30% equity rally).  At the sponsored seminar, we would expect the Russell LifePoints target date series to be portrayed as a superior answer to navigating the current market environment.  Still, retirement plan sponsors should consult with an unconflicted expert to vet the content of any seminar, article, and online tool.

Fiduciary analysis

Practically speaking, most investment advisors and consultants can provide substantial quantitative investment analysis.  Investments are relatively simple to dissect and analyze.   Furthermore, a number of insightful consultants should also be able to provide thoughtful qualitative analysis as well.  However, recall the primary reason target date funds are becoming so popular is because of their ability to become a QDIA.  The QDIA designation is the result of legislation and fiduciary standards.  Some investment-centric advisors may miss some of the important legal distinctions to various target date products.  

Most target date products – indeed, most investments - accept fiduciary responsibility for their product.  However, one of the most popular passive target date series in the USA does not accept fiduciary responsibility.  This passive target date series is the combination of other investments (a US stock market fund, an international stock fund, etc.) which do individually accept fiduciary responsibility.   The model which the investment manager uses to combine all of the underlying funds into a single product is considered an education tool.  In other words, the fund does not provide QDIA safe harbor provisions.  Therefore, plan sponsors and investment committee members who select such funds do not have safe harbor protection, and may be more liable for the performance of this series than they realize. 

It may surprise you that few investment advisors or consultants are aware of this distinction.  It may trouble you to realize that investment consultants may have unwittingly exposed their clients to unnecessary risk.  We consider expertise in fiduciary standards a best-practice for consultants selected to advise retirement plan sponsors because of situations like this.

Closing recommendations

Given the complexity of the target date fund universe and the existence of dozens of completely rational, but disparate approaches to target date solutions, how do you know which solution is best?  A retirement plan sponsor should seek clarity by first understanding the needs of their employees.  Understand your participant demographics and how that affects your target date solution.  What other retirement programs – like a pension or an ESOP – exist for the employees?  What is the typical salary range?  How long do employees stay with the company?  How much time do they spend managing their investments?  Are employees contributing to their retirement at a healthy rate?  These considerations will help determine what features of a target date solution would be most useful to your employees. 

Ultimately, evaluating target date funds is more of an art than a science, and there may be several funds which fit the needs of the participants.  The purely scientific process of measuring results is straightforward.  The art of evaluating target date funds requires thoughtful insights into the needs – expressed and unexpressed of your plan participants, and satisfying those needs with the options available in the market. 

Reprinted with the permission of ThomsonReuters, (c)2014 in the Journal of Compensation and Benefits.)

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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