Jury still out on closed vs. open architecture of target-date funds

Morningstar Inc. still can't determine whether open architecture is better than closed architecture in the design of target-date funds.

Two years ago, the Chicago-based financial research firm issued a report saying there was no correlation in performance among fund families that used outside subadvisers, in-house managers or a mixture of the two.

Nearly three weeks ago, the firm said it can't declare a winner. “New data, same story” was the headline in a Morningstar report.

“It validates what we saw two years ago,” Joshua Charlson, senior fund analyst, said in an interview.

“In theory, broadly speaking, choosing the pick of the litter should provide an advantage, but it doesn't,” said Mr. Charlson, referring to sponsors offering open-architecture target-date funds.

“Our research doesn't invalidate the choice of someone who wants diverse managers,” said Mr. Charlson, adding that his firm views each architecture approach equally.

When Morningstar issued its first architecture report in 2010, Mr. Charlson noted at the time that the industry was still relatively young and that extra years of data could produce a more comprehensive analysis.

Today, there are more target-date fund families with at least three years of performance history, but the latest research “fails to support the contention that open-architecture target-date funds are superior to closed-architecture offerings,” the Morningstar report said. “If anything, closed architecture series appear to have a slightly better track record.”

Morningstar identified three design categories:

  • There were 21 target-date series with closed architecture, meaning 90% or more of a target-date series' assets came from a provider's funds or funds of an affiliate.
  • Seven target-date series offered open architecture, in which 10% or less of the assets came from a provider's funds.
  • And there were 11 mixed target-date series, in which the percentage of assets for provider and non-provider funds fell between the two extremes.

“Most series labeled mixed should probably be considered in tandem with open series, since managers of most mixed series theoretically have the opportunity to invest 100% in external subadvisers if they wish,” the report said.

Morningstar analyzed the differences among various target-date styles — closed, mixed, open and the combination of open and mixed architectures — and found no statistically significant differences.

Morningstar reported that:

  • For the period ended Dec. 31, 2011, the annualized average three-year risk-adjusted return for the closed-architecture group was 9.92%, while the average for the combined open and mixed architectures was 9.11%.
  • The annualized average five-year risk-adjusted return for the closed group was -3.16%, and the average for the combined open-mixed group was -2.95%. The five-year results were affected by several open-architecture series having “notably conservative glidepaths,” the report said.
  • The average three-year “star” rating for the closed group was 3.55, and the average for the combined open-mixed group was 3.06. The average five-year rating was 3.31 for the closed group and 3.32 for the open-mixed group. Morningstar's star system – five is for the best performance; one is for the worst – is a risk-adjusted measure of target-date funds in each fund family.
  • Stripping out the impact of glidepaths from the star-rating analysis, Morningstar created an “underlying star” rating that focuses only on the quality of underlying holdings. This rating for the closed group was 3.49 vs. 3.32 for the combined open-mixed group. Over five years, the average closed group rating was 3.59 and the open-mixed group score was 3.27.

Morningstar also evaluated open vs. closed architecture by using its analysis of 22 large target-date fund families, which the firm updates every quarter. The fund families are placed in five categories — top, above average, average, below average and bottom. They are evaluated on five criteria: performance, portfolio quality, price, fund managers and the fund families' corporate parents.

Once again, Morningstar couldn't find a correlation in this group of 14 closed and eight open or mixed target-date series.

The four series in the top ranking — Vanguard Group Inc., T. Rowe Price Group Inc., J.P. Morgan Asset Management (JPM) and American Funds — are closed architecture by Morningstar standards. The two series ranked at the bottom — DWS Investments and OppenheimerFunds Inc. — also are in the closed architecture group.

“Above average and below average ratings are split between closed and open or mixed series types,” the report said. “While closed funds have cornered the highest ratings in this system, overall the ratings are evenly distributed.”