My name is John Rekenthaler. I am vice president of research for Morningstar. Thank you for inviting me to speak today before the Senate Committee on Aging.
Morningstar is a leading provider of independent investment research and the largest provider of mutual fund research in the United States. Recently, Morningstar published a detailed report on target-date mutual funds, creatively titled Target-Date Series Research Paper: 2009 Industry Survey
. My presentation today contains key findings from that report.
I would like to state upfront that Morningstar is generally supportive of target-date funds. Throughout its history, Morningstar has frequently criticized entire categories of funds for being gimmicky and/or overpriced. We are considerably more positive about target-date funds. We regard target-date funds as being a sound invention that meets a true investor need. By offering broadly diversified portfolios that change over time, target-date funds are a suitable choice for those who wish to delegate their investment decisions. They also are well suited for inactive owners who will not be making trades as they grow older and their situations change.
That said, there are certain concerns, given the extraordinary position that target-date funds now occupy as the default investment of choice for America's New Retirement Model. These concerns include:
- Variation in fees
- The use of proprietary (in-house) funds
- Lack of manager ownership
- Variation in glide paths among the shorter-dated funds
- Lack of transparency
The first concern lies with fees. Overall, annual expense ratios for target-date mutual funds compare favorably with the expense ratios charged by other types of mutual funds. For example, on an asset-weighted basis, that is with the larger funds counting proportionately more in the calculation than the smaller funds, target-date funds have an average annual expense ratio of 0.69%. This is lower than the 0.82% figure for so-called "allocation" funds, which also invest in a broad mix of stocks and bonds.
However, the average conceals a very wide range among the 48 target-date fund families that we track. On the low end, one target-date family has an expense ratio of only 0.19%. On the high end, another has an expense ratio of 1.82%--more than 9 times higher than the first family. The issue of expenses is particularly important with target-date funds because of their very long time horizons. Several fund families today offer funds with a 2055 date--46 years into the future! As the Committee well knows, the power of compounding greatly magnifies small differences over such a long time period.
For example, let's assume two target-date funds that invest in identical underlying assets, returning 7% annually. One fund boasts the industry's low expense ratio of 0.19% and the other has the industry's high expense ratio of 1.82%. Over the 46-year time period mentioned above, an initial investment made in the low-expense fund would become worth more than twice as much as the investment that was made in the high-expense fund. (A lump-sum investment of $1,000 in the two funds would grow to $20,708 and $10,208, respectively.) Few employees who are defaulted into target-date funds through their 401(k) plans will be aware of the expense differences that exist among funds, and fewer still will understand their very powerful effects.
The second concern is the tendency of target-date funds to invest solely in their own company's underlying funds. No reputable institutional investor would hand over his or her entire portfolio to a single asset-management firm. Instead, the institutional investor sifts among the many investment managers that make up the industry, seeking to purchase the best and lowest-cost options for various slices of the portfolio. One firm gets a portion of the portfolio's large-company stocks, another manages its short-term Treasuries, a third takes control of its emerging-market investments, and so forth. The institutional investor would not expect a single firm to excel at all types of investing. Yet that is implicitly the position taken by most fund families in running their target-date funds. It is difficult to square such a practice as being the best outcome for an investor--although of course from a business perspective, it is understandable that a target-date fund family would like to keep all of the assets collected in-house.
Third, we are worried by the low level of conviction placed by the industry's target-date investment managers in the funds that they run. Morningstar tracks how much money a target-date manager invests in his or her own funds, as this is an item listed in each fund's Statement of Additional Information. After all, target-date funds would seem to be the ideal way for a fund manager to "eat his own cooking" (as the saying goes), given that target-date funds are openly marketed as being suitable for every possible type of investor. Yet only two out of 58 target-date managers whom we track list $500,000 or more invested in their own funds. Even more strikingly, 33 of the managers, or 57%, show nothing at all.
It is true that there are mitigating circumstances. In some cases, target-date managers can only invest in their funds through 401(k) plans, as those funds are not available in a retail account. In other cases, the managers hold a different version of their fund, one that is not a registered mutual fund but is instead an institutionally priced separate account that is available only for larger 401(k) plans. (However, this does beg another question, as the typical investor will not necessarily be able to avail himself of this lower-cost option.) But the point remains: Manager ownership is light. Overall in the fund industry, managers who invest heavily in their own funds tend to outperform those who invest less. We would like to see fund managers more enthusiastically embrace target-date funds.