Passive target-date funds picking up the pace

Investors wooed by lower costs, less risk than active offerings

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Choosing: Josh Charlson believes the passive funds can be more predictable.

Assets invested in passive target-date funds are growing at a much faster rate than those in active target-date funds, although active funds still have a substantial majority of assets.

As a result, passive target-date funds are taking a bigger piece of the total target-date pie — 30.5% as of July 2012 vs. 14.6% for year-end 2006, according to Morningstar Inc., Chicago.

Passively managed funds held $134.5 billion in assets as of July, an eight-fold increase since year-end 2006, according to Morningstar.

Actively managed target-date funds reported assets of $306.5 billion in July, more than triple the amount in 2006, the year the Pension Protection Act took effect. (All statistics exclude custom funds, for which no comprehensive data is available.)

Although lower costs motivate sponsors to seek passively managed funds, other reasons for their growth include “a desire for less active manager risk, less tracking error, less volatility and more predictability,” said Josh Charlson, senior mutual fund analyst for Morningstar.

But Mr. Charlson isn't sure passive funds will ever overtake active ones because of “barriers to entry” for firms wanting to join the fray. Among them: “Can you compete on price with other providers” already in the market? “Do you have existing index funds in-house that provide enough diversification to create a target-date fund? Do you have enough expertise in index funds?”

(Morningstar defines a passive target-date fund as containing 90% or more passively managed investments.)

Thirteen of the 40-plus target-date providers offer passive funds, with Vanguard Group Inc. accounting for 83% of the market, at $89.9 billion in passive target-date fund assets as of Dec. 31, according to Morningstar. Last year alone, its assets grew 16%.

The Wells Fargo Advantage Dow Jones Target series, with $10.8 billion in year-end 2011 assets, placed a distant second with 10% of the market. Assets grew 18%, reflecting both market gains and contributions during 2011.

One provider of passive target-date funds is bowing out. American Independence Financial Services LLC, New York, announced it July that it would liquidate its index-based NestEgg series, which has approximately $135 million in assets.

NestEgg had been available through American Independence and a predecessor firm since 2000. American Independence said it would have had to build or buy a record-keeping system to compete in the target-date market, and it decided the cost was too great.

In recent years, several prominent providers have begun offering passive target-date funds in addition to active ones.

Ranked third

Fidelity Investments, Boston, unveiled an index version of its active Fidelity Freedom series in late 2009. By the end of 2011, Fidelity Freedom Index ranked third on Morningstar's list of passive target-date fund providers with $3.2 billion in assets.

“We look at trends in the industry and appreciate some clients specifically want a passive strategy,” said Susan Powers, Fidelity's senior vice president of investment consulting, explaining why the firm offers a passively managed target-date series. “We want an array of products to satisfy the broad needs of our clients.”

As of June 30, the Fidelity Freedom Index target-date funds had $4.7 billion in assets, while the actively managed Fidelity Freedom series had $125.5 billion. The firm also offers the actively managed Fidelity Freedom Advisor target-date series, which had assets of $15.3 billion.

John Hancock Financial Services, Boston, launched its John Hancock Retirement Choice series of passive target-date portfolios in April 2010, and it ranked fourth in Morningstar's list with $1.2 billion in assets at the end of 2011.

Initially, the series had equity index funds and passive fixed-income exchange-traded funds. Last April, the company replaced the equity component with a strategic equity allocation fund of stocks that replicate several indexes, said Steven Medina, senior managing director and head of global asset allocation for John Hancock Asset Management in Boston.

The asset allocation is actively managed to permit “a more precise expression (of the fund managers') views and forecasts,” Mr. Medina said. For example, managers can “target a certain weight for a foreign country rather than for the entire foreign equities class,” he said.

John Hancock offered its first target-date series in October 2006, now called John Hancock Retirement Living, in which the majority of underlying investments is actively managed.

Hancock is seeing more money flowing into its passive target-date series than into the original series. One reason is price: The expense ratio for the new funds is about 18 basis points cheaper.

As of June 30, the original target-date series had more than $5.5 billion in assets while the passive series had more than $2 billion, Mr. Medina said. Year to date, the inflows for the passive series “are well over double” those of the original series, he said.

Greater growth

BlackRock (BLK) Inc. (BLK), New York, began offering LifePath Index, its passive target-date mutual fund series, in May 2011. LifePath Index had assets of $910 million as of Aug. 31, 2012. The company's actively managed LifePath target-date series, introduced in March 1994, had assets of $8 billion as of Aug. 31.

Chip Castille, managing director and head of the U.S. and Canada defined contribution group, said he expects greater growth as executives at more small and midsize plans follow the lead of larger plans by adding passively managed target-date funds.

Another recent entrant to the passive market is Lincoln National Corp., Radnor, Pa., which introduced its Presidential Protected Profile target-date series in November 2011. The series had assets of $21 million as of Aug. 31, said David Weiss, vice president of the company's Lincoln Investment Advisors subsidiary in Concord, N.H.

Lincoln uses exchange-traded funds for its target-date series which is available in institutional and retail shares. Mr. Weiss said the company chose the ETF approach because clients and potential clients are focusing on fees and expressing a greater interest in ETFs. “I can gain access to asset classes efficiently” by using ETFs, Mr. Weiss added. “It's easier for me to develop a portfolio.”

This article originally appeared in the September 17, 2012 print issue as, "Passive target-date funds picking up the pace".