How do market watchers come up with apples-to-apples comparisons of target-date funds?
As the number of target-date funds continues to multiply, a debate is beginning to emerge about how to measure which ones are fulfilling their mission as a one-stop retirement planning solution, and which are falling short.
The absence of a standardized benchmark has left financial advisors to wade through the burgeoning number of fund choices with only vague and often conflicting guidelines for evaluation. "It's a challenge for financial advisors and plan sponsors to establish an appropriate benchmark that they can use to monitor performance on an ongoing basis," says Patrick Cunningham, managing director at Manning & Napier, which has offered target retirement funds since 1993. "When you have one 2020 fund with 87% of its assets in equities and another with 47%, it becomes a question of whether you are really looking at the same animal."
In late August, fund giant Vanguard weighed in on the controversy with a report that noted the lack of a meaningful benchmark to measure target date fund performance. "As target date funds continue to assume a larger role in workplace retirement plans the need for benchmarks that can help investors assess their progress toward a financially secure retirement will become more pronounced," it warns.
Finding an acceptable yardstick is not as simple as it may appear at first glance. The investment mandates of most mutual funds are narrow enough to have a relevant peer group or index for comparison purposes. Target-date funds share some common characteristics as well. They all allocate assets into different fund baskets based on specific retirement years, such as 2010, 2020 or 2030. The initial mix, which may include stock funds, bond funds and perhaps real estate or international funds, shifts to more conservative allocations as retirement approaches and usually becomes even more conservative after the target date passes.
But beyond those features they can be vastly different from one another. Funds with the same target date often have very different asset allocations. Some move along a predetermined "glide path" asset allocation toward the target date, while others tweak allocations within a certain range along the way to take market conditions into account. The percentage of assets allocated toward equities at the target date and afterward also varies, as does the short- and long-term performance of the funds. Some have exposure to alternative asset classes such as commodities or real estate, while others do not. Most are a mix of actively managed funds, although index offerings are also popular.
Measuring risk is tricky, observes Joe Nagengast, founder of Turnstone Advisory Group, an advisory and research firm in Marina del Rey, Calif. "Most risk measures such as standard deviation require at least three years of performance history, and the majority of these funds don't have that," he says. Even if a fund has been around for a while, he adds, shifts in asset allocation mean that risk characteristics a fund has displayed in the past won't necessarily apply today or in the future.
Cunningham says investors should look beyond absolute returns to how well a fund provides capital growth during positive markets and down-market protection during bear markets. The problem is that only a few funds have been around long enough to have a track record that covers both bull and bear markets.
Target-date fund sponsors benchmark performance differently, and a particular fund can look like either a standout or an also-ran depending on what it is being compared against. Some rely on comparable indexes, such as the Standard & Poor's 500, the Russell 3000 or the Lehman Brothers U.S. Aggregate Bond Index, in proportion to their funds' respective asset allocations. So if a fund has an 80/20 split between stocks and bonds, for example, the benchmark would consist of an 80/20 split of comparable equity and bond indexes. Others use peer-group comparisons across target-date funds with similar dates.
Both methods have their drawbacks. Peer-group comparisons may reveal how a fund stacks up against the competition, but do not take into account widely varying asset allocations among the funds. A fund that has a higher-than-average allocation to equities may look significantly better than competitors in bull markets but have less downside protection. Peer averages may only provide a broad-brush snapshot. Morningstar divides target-date funds into three groupings: 2000-2014, 2015-2029 and 2030 and beyond. That means funds within the same grouping can be as much as 15 years apart in peer comparisons. At the same time, using indexes that correspond to a respective asset class eliminates apples-to-oranges comparisons among peers, but doesn't address the issue of how managers are handling asset-allocation decisions.
The most ambitious attempt to come up with a comprehensive yardstick is the series of Dow Jones Target Date Indexes. Introduced in April 2005, the ten indexes cover target dates in five-year intervals out to the year 2045. Each index is a composite of other Dow Jones Indexes that represent the three major asset classes of stocks, bonds and cash. The asset classes are weighted within each target date index to reflect a targeted level of risk, and the weights are adjusted based on a predetermined formula to reduce the level of potential risk as the index's maturity date approaches. Index returns are calculated monthly for each target date.
So far, just three firms-Wells Fargo, American Independence Financial Services and State Street Global Advisors-have adopted the Dow Jones Target Date Indexes as a basis for their life-cycle funds. A number of other firms measure their funds' performance against comparable Dow Jones indexes in shareholder literature but continue to manage the funds themselves.
At J. & W. Seligman & Co., which offers a series of target-date funds that invest in exchange-traded funds, shareholder reports benchmark performance against the corresponding Dow Jones Target Date indexes as well as the Lipper peer group. Before the indexes became available, the firm had used the Standard & Poor's 500 and the Lehman Brothers U.S. Aggregate Bond index in proportion to their appearance in the funds for comparison purposes, according to Gary Terpening, product manager at Seligman.
Terpening says that while the newer benchmarks are a "reasonable" basis for comparison and an improvement over previous methods, they are not perfect solutions. Returns for the Lipper peer group average and the relevant Dow Jones index can differ significantly from each other. The firm's latest prospectus for the firm's TargetFund 2015 underscores the point. For the year ended Dec. 31, 2006, the fund's C shares had a total return of 14.83%, compared with 9.65% for the Dow Jones Target 2015 Index and 11.63% for the Lipper peer-group average. Morningstar uses the Dow Jones indexes as well as average peer-group returns in performance comparisons, and in some years the performance gap between the two has been substantial.
Cunningham believes that the indexes are a "good start" toward measuring performance, but points out that they are relatively new and their longer-term performance is based on hypothetical models. "They also allocate more than the average target date fund to small and mid-cap stocks, which has helped boost performance over the last few years," he says.
The discrepancy occurs largely because the equity sub-indexes within the Dow Jones indexes, such as large-cap growth, small-cap value and mid-cap value, are equally weighted. The approach, while it may have merit as a benchmarking tool and eliminates some of the biases associated with market-cap weighting, does not correspond to the market-cap-weighted approach that most life-cycle funds use in their equity allocations.
Still, proponents say a third-party gauge is better than a self-constructed (and potentially self-serving) yardstick. "While other target-date fund managers benchmark their performance against a custom index of their own creation, we feel the Dow Jones Indexes are well-constructed and offer investors an objective and transparent measure of success," notes managing director Michael S. Dalis on State Street Global Advisors' Web site. The Vanguard report recommends "goals-based benchmarks" based on returns required by a typical investor to achieve sufficient retirement savings and a fund's performance relative to the investment manager's expectations.
At this point, the debate about measuring target-date fund performance may be of greater interest to fund sponsors and those who license target-date fund indexes than to some financial advisors. Charles Buck of Buck Financial Advisors in Woodbury, Minn., says that he "has yet to look at target-date fund benchmarks." He uses Vanguard's target-date funds because he likes their passive indexing approach, their low expenses, and the fact that he invests extensively in the firm's other index funds. He typically recommends them as a simple way to diversify for new investors with smaller accounts, or for larger clients who may have a small satellite account such as a Roth IRA. "If someone has a life-cycle fund in a 401(k) plan and asks me what I think of it, I look at the Vanguard funds as a benchmark," he says.
Mark Ferris, a financial advisor in Branford, Conn., views attempts to apply a consistent yardstick with skepticism. "The philosophies and strategies behind each one are so unique that I don't believe benchmarking them is possible," he says. "Just because a fund has been performing well over the last few years doesn't necessarily mean it will be the one that leaves someone with the largest balance in the year 2030. My clients who use life-cycle funds are interested in simplifying their financial lives or adding some discipline to their portfolios. The question of comparative performance never even comes up."
