Open, closed? Fund structure war continues

If combatants in the debate over target-date fund investment approaches thought Morningstar Inc. could provide a tiebreaker, they were out of luck.

A recent Morningstar report found no correlation in performance among selected fund families that used in-house investment managers, outside subadvisers or a combination of the two.

“We tried to look for patterns, but nothing popped out,” said Josh Charlson, senior fund analyst for Chicago-based Morningstar. “This study is setting a baseline to determine changes over time.”

Morningstar looked at several measurements — including risk-adjusted returns and investment manager skill — but it couldn't offer a verdict on open architecture vs. closed architecture.

Because many of the target-date fund families are young, Mr. Charlson said Morningstar will have to wait a few years to determine whether there's a link to performance by target-date approach. “Five-year records will be more telling than three-year records,” he said. “Five-year records will even out the volatility (of 2008 and 2009).”

Morningstar began offering quarterly analyses of target-date funds in September. The latest report, issued in March, was the first effort to digest architecture.

Of course, an inconclusive conclusion about target-date architecture and performance enabled various practitioners to defend their approaches and rebut their critics.

For example, T. Rowe Price Group, Baltimore, which employs closed architecture, had $43.7 billion in target-date fund assets by the end of 2009, said Jerome Clark, portfolio manager of retirement-date funds.

“So that means we are talking to plan sponsors who are very sophisticated and who, nine times out of 10, have a consultant,” he said. Such scrutiny by clients and consultants punctures the critics' argument that closed-architecture companies can use target-date funds to hide weak managers, said Mr. Clark, adding, “We have no incentive to put a poor performer into our lineup.”

Open-architecture companies offer an equally strong defense for their approach. “We never thought about doing it any other way,” said Wayne Wicker, senior chief investment officer of ICMA-RC, Washington, sponsor of the Vantagepoint Milestone target-date fund family, which uses only outside investment managers.

The Morningstar report called Vantagepoint Milestone a “standout” among open-architecture funds. The fund family benefited from “strong manager selection, a relatively conservative glide path, reasonable — though recently increased fees —and a stellar and experienced investment culture,” Morningstar said.

ICMA-RC manages and administers retirement plans for public-sector employers and employees. Of its approximately $34 billion in retirement assets, $1.2 billion are held in target-date funds.

Mr. Wicker said economies of scale help his target-date fund family address an issue raised by critics that open architecture can elevate costs because of using many outside managers. “This provides us with the ability to negotiate a lower cost basis,” Mr. Wicker said. Smaller open-architecture fund families don't have this advantage, he said.

Aside from debates over cost and staffing, several other broad issues dominate the target-date discussion, as outlined by the Morningstar report:

• Proponents of closed architecture say the use of in-house investment managers reduces costs and gives fund company executives more control over the investment approaches. Closed architecture is good for the fund company because it doesn't have to share management fees with subadvisers or track the trading and compliance behavior of outsiders.

• Critics say closed architecture raises conflict-of-interest risks, enabling the fund company to bulk up on certain asset categories to raise profits. They say plan participants face “considerable single-firm risk,” especially if participants put all of their retirement assets in a single target-date fund.

• Proponents of open architecture say their approach is best because it enables a provider to search for the best fund managers, rather than rely on a relatively narrow group of in-house investment managers. Casting a wider net offers a chance to find better returns and more diversification. Critics say the search for multiple outsiders can be difficult, time-consuming and expensive.

Despite the partisan talk, Morningstar's numbers don't reveal a trend, as in the case of the analysis of annualized risk-adjusted returns for the three years ended Dec. 31. Thanks to the stock market turmoil in 2008 and early 2009, all 37 target-date fund families in this analysis had negative returns.

Four of the five best performers — and seven of the top 10 — employed closed architecture. Four of the five worst performers — and five of the bottom 10 — also use closed architecture.

“Although we may see some clustering at the top or bottom, the evidence isn't strong enough to make a conclusion,” said Laura Lutton, editorial director of mutual fund analysis for Morningstar. “We're still looking at a short period of performance.”

For risk-adjusted returns, the list shows T. Rowe Price placed 19th while Vantagepoint Milestone placed eighth. Target-date funds from ING Investment Management, Hartford, Conn., had sharply divided results: An actively managed portfolio, ING Solutions, ranked 32nd while the passive portfolio, ING Index Solutions, placed third.

ING offers an open-architecture variation, with 30% of assets in the active portfolio managed by ING and affiliates, and 70% managed by outsiders. In the passive portfolio, ING manages the equity component and Neuberger Berman handles the bond component.

The passive-portfolio family was able to soften the blows suffered by the active-portfolio family, which had “significant volatility” due to investments in such areas as emerging market equities, high-yield bonds and real estate investment trusts, said Bill Evans, senior vice president at ING Investment Management. Passive funds outperformed active funds in 2008, he said.

As of March 31, ING had $4.73 billion in target-date fund assets, of which 78% was in the active-portfolio family.

Mr. Evans disagreed with the criticism that open-architecture performance will be held back by higher fees. “The difference in fees between totally open and totally closed isn't so big that you can't make up the difference with (hiring) good managers over time.“

Manager skill is another way Morningstar measured performance, but this analysis was inconclusive, too. Morningstar examined 32 fund families for the two years ended Dec. 31, comparing individual families' stock-picking and fund-choosing to peer group norms.

Four of the top five practice closed architecture — and so do four of the five worst performers. “I think it's more of a random aspect of the small sampling,” said Mr. Charlson of Morningstar.

In this analysis, Vantagepoint Milestone was fifth and the ING active-portfolio family was 25th. The closed-architecture families from T. Rowe Price and J.P. Morgan Asset Management, New York, placed first and second.

“You need a very deep team” of managers for target-date funds, said Anne Lester, managing director at J.P. Morgan Asset Management, whose SmartRetirement family placed 10th in Morningstar's risk-adjusted return rankings. As of March 31, total assets under management for its target-date offerings — mutual funds, collective investment trusts and separate accounts — was $5.2 billion.

“We consistently evaluate our roster of managers,” she said. “We have made a number of changes. To improve our risk-adjusted portfolio, we have made changes to remove strategies that didn't work.”

Ms. Lester argued that closed architecture provides better quality control and cost control than open architecture. “Picking managers isn't easy to do,” she said. “By the time you hire the managers, you may have priced yourself out of the market.”

With all the mixed results, the big winner may be Morningstar, which will continue to crunch the numbers. “The performance data hasn't been conclusive about whether open or closed is better,” Ms. Lutton said.