Perspective: Cost and Concentration: Pros or Cons in Target-Dates?

Target-date mutual funds, also called lifecycle funds, are exploding in popularity.

Net flows surpassed $41 billion in the first three quarters of 2007, according to Financial Research Corporation – compared with $34 billion for the full calendar year 2006 – and forecasters expect the trend to continue. Driven in large part by retirement plans, the growth is testimony to the ease and effectiveness of the target-date investment structure.

But with this proliferation has come criticism. The vast majority of target-date funds are structured as funds-of-funds, and many use only the proprietary funds of a single investment manager as underlying investments. Consequently, some say, target-date funds carry a needless additional layer of expenses as well as the risk of being too concentrated in the offerings of one manager.

However valid these two arguments may be for any given target-date fund, they are important considerations for financial advisers and plan sponsors. Let’s take a look at each.

Costs. Consideration of expenses involves two key questions: How much are participants paying, and what are they getting?

Thanks to regulatory requirements that went into effect January 1, 2007, the answer to the first question is easy. As of that date, any registered open-end fund investing in a certain amount of shares of another fund(s) – in other words, a fund-of-funds – must include in its prospectus fee table an additional line item titled “Acquired Fund Fees and Expenses’ under the section that discloses total annual fund operating expenses. According to the SEC, the action will improve transparency.

A second requirement became effective April 1 and requires fund sales material containing performance to disclose the fund’s total annual operating expense ratio, gross of any fee waivers or expense reimbursements (the unsubsidized expense ratio), as stated in the fee table of the fund’s prospectus. This helps an adviser and plan sponsor get a more realistic sense of expenses.

As part of the expense assessment, pay special attention to the nature of any fee waivers or reimbursements. Many are voluntary and could end at any time. Others are contractual.

How plan sponsors and participants benefit from a fund-of-funds structure is less quantitative but equally important. First, the traditional mutual fund structure (the fund-of-funds “wrapper’) simplifies operational issues and is familiar to most participants. The structure also helps insulate participants from the volatility of underlying investments and reduces the temptation to tinker with a strategy. As a result, participants are far more likely to stick with a target-date strategy long enough to reap its benefits.

Probably most important in answering the question of “What are the participants getting?’ is consideration of increased diversification and the potential for higher returns relative to cost. For longer-term target-date funds, for example, look for asset classes that historically have offered low correlations with the typical lineup of domestic large-cap and small-cap equities, such as emerging markets, international small-caps and equity REITs. For the shorter-term funds, particularly those intended to take a participant into retirement, you may want to include an asset class such as inflation-protected Treasury bills, typically called TIPs.

Underlying investments in those asset classes typically carry higher fees, but we believe that the investment merits of increased diversification and return potential justify the marginal incremental costs.

Proprietary Funds. In addition to pointing out a lack of manager diversification, critics of target-date funds say that the funds often include a manager’s less-than-stellar offerings. Although time consuming, resolving this issue is relatively easy by screening the underlying holdings individually.

A related consideration is the question of “active’ versus “passive.’ On the one hand, a suite of proprietary funds can provide access to a star manager that you and the plan sponsor expect to outperform. But with that expectation will likely come the short-term volatility that typically accompanies outperformers. An alternative is a suite of target-date funds that use index funds or ETFs as the underlying investments.

See the first column in this series: Perspective: Why Plans That Need Target-Date QDIAs Need You

Gary Terpening is Research Analyst, Seligman TargetHorizon ETF Portfolios of Seligman Advisors, Inc. The Funds are distributed by Seligman Advisors, Inc.

Diversification does not insure a profit or protect against loss in a declining market.

The views and opinions expressed are those of the commentator as of November 2007, are provided for general information only, and do not constitute specific tax, legal, or investment advice to any person. Opinions, estimates, and forecasts may be changed without notice.

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