The Case for ‘Blend’ TDFs

PIMCO says that rather than go with an all-actively managed target-date fund (TDF) or an all-passively managed TDF, a mix of the two makes sense—and that there is particular logic to assigning the fixed income portion of the portfolio to active management due to outperformance.

It used to be that retirement plan sponsors only primarily considered active target-date funds (TDFs) for the lineups of qualified default investment alternatives (QDIAs), as these funds captured 90% of the market in the early 2000s, according to a white paper from PIMCO. However, because of concerns about fees and litigation risk, three years ago, passive TDFs surpassed active TDFs in market share.

Erin Browne, managing director at PIMCO, tells PLANADVISER that there is a third option that retirement plan advisers should consider, particularly because this option “is, by and large, what plan sponsors and consultants are looking for.”

The option? “Blend” TDFs that combine both active and passive management. “We poll the largest plan sponsors and consultants each year,” Browne says. “By and large, mid and large plans are looking for a blended strategy.”

A PIMCO survey found that 60% of plans with $1 billion or more in assets are looking for custom TDFs, which typically use a mix of active and passive investments. Only 25% of plans in this size range are looking for off-the-shelf blend TDFs.

What becomes interesting is that most plans below that size are looking for blend TDFs, probably because their assets are not large enough to command a custom TDF. Forty-seven percent of plans in the $500 million to less than $1 billion space are looking for blend TDFs, and this is true for 50% of those in the $200 million to less than $500 million bracket, for 47% of those in the $50 million to less than $200 million bracket, and 44% of those with less than $50 million in assets. Clearly, sponsors are looking for blend TDFs.

While the amount of TDF assets that are in blend TDFs now is small, Morningstar data show that blend TDF assets have grown 485% since 2013. “While it is a small segment of the market today, we think it will be the largest growth opportunity in the TDF market,” Browne says.

The reason sponsors are looking for a blended strategy is because “selecting active management on equity is not the best decision,” Browne says. “The percentage of active equity funds that outperform their benchmark is only 20%, whereas 70% of fixed income active managers are able to outperform their benchmark.”

As PIMCO says in its white paper, “In our view, the pendulum has swung too far from active to passive, and a compromise that incorporates investment considerations may be warranted. … A blend TDF typically carries lower fees than fully active options. In addition, blend TDFs offer alpha potential from active management, which over the long term may translate into higher income-replacement ratios or improved longevity of assets in retirement versus a fully passive TDF, typically for only a modest fee premium.”

The reason why actively managed fixed income funds are able to outperform their benchmarks so much more often than actively managed equity funds is because  there are only about 1,000 equities on the market but tens and even hundreds of thousands of fixed income options traded over the counter, Browne says. This creates inefficiencies that active fixed income managers can exploit.

Additionally, “within fixed income, you have non-economic buyers: sovereign wealth funds, treasury managers, pension managers, currency managers, central banks,” she adds. “This creates additional alpha opportunities and is a big component” of why actively managed fixed income makes more sense than actively managed equities.

On top of this, according to PIMCO, actively managed equities cost an average of 61 basis points, versus only 33 basis points for actively managed fixed income.

PIMCO’s mantra, Browne says, is, “Go active where it matters [fixed income] and passive where it saves [equity].”

Finally, PIMCO notes that as investors approach or enter retirement, a greater portion of their TDF glide path is allocated to fixed income. Since actively managed fixed income has borne out to be superior to equities, doesn’t a blend TDF make even more sense?