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Low cost should not be sole factor for buying target-date funds

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CHICAGO — The lure of low fees is attracting a record flow of assets into target-date mutual funds, but clients investing for retirement need to consider more than price, says Morningstar analyst Jeff Holt.

Target-date fund assets hit $1 trillion in assets last year, driven largely by an overwhelming flow of money into the passive end of this retirement strategy, Holt told advisors attending a session on retirement research at Morningstar's annual investment conference.

Indeed, 95% of last year's estimated $70 billion in net flows into TDFs went to passive funds, according to Morningstar's 2018 Target-Date Fund Landscape report. Moreover, over 40% of target-date funds are now passive, up from 24% in 2008, and Holt expects assets in passive funds to exceed those in actively managed target-date funds in the near future.

The trend, however, is due "less to a belief in passive funds and more to a belief in lower cost," said Holt, a Morningstar director. Indeed, the cheapest target-date funds can cost as little as eight basis points, while actively managed target-date funds can cost over 60 basis points, he noted.

But cost alone shouldn't determine which target-date funds clients should buy for retirement savings, he cautioned.

"There are a lot of differences in target-date funds," Holt told advisors. "Consumers need to identify and understand what's behind them and peel back the layers."

When counseling clients on target-date funds as a retirement investment, Holt said, advisors should examine factors including:

  • The equity glide path: Target-date funds shift asset allocation as an investor approaches retirement. "Looking at a target-date series strategic equity glide path, which indicates the anticipated equity stake at different points before and after the target retirement date, is the simplest way to follow the shifts," according to the Morningstar report.
  • The fund's holdings and exposure: Advisors should be comfortable with the fund's holdings in U.S. versus non-U.S. assets; large-cap stocks versus small-cap and exposure to high-yield bonds and TIPS, Holt says.
  • Management team: "Beware of excessive turnover and make sure the team has depth," Holt says. What's more, the results of target-date funds often depend on the effectiveness of underlying portfolio managers because many target-date series employ a fund-of-funds structure, the Morningstar report notes. "This warrants an examination of underlying funds," the report recommends.
  • Performance: The performance of a target-date fund, no matter how low the cost, can be disappointing and far from a guarantee that a client will have enough savings for retirement.

The Morningstar report points out that while target-date portfolios tend to be diverse, U.S. large-cap stocks have generally been the top-performing investment over the past several years.

Using the S&P 500 as a proxy for U.S. large-cap stocks, the report shows that an investor with $10,000 (assuming no additional contributions) would have ended up with nearly $21,000 by investing only in U.S. large-cap stocks over the past five years through December 2017, compared with just under $16,000 with the average return for a 2040 target-date fund and less than $14,000 for a 2020 fund.

These results, the report says, "may lead investors to question the merit of diversifying beyond U.S. stocks."

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