Providers focus on blending in target-date funds

In a crowded target-date fund market, some of the newest fund entrants are emphasizing a blend of active and passive investments, trying to distinguish themselves from competitors offering an all-passive or all-active approach.

The reasons for blending strategies vary. In some cases, for example, providers of existing target-date series added another option to attract new defined contribution clients or provide a choice for current target-date fund clients.

In other cases, providers of blend target-date funds are marketing their off-the-shelf offerings as an option to DC plans that aren't big enough to offer, can't afford or don't want to pursue a custom target-date portfolio.

“Large DC plans use custom target-date funds to be flexible,” said Richard Fulford, executive vice president and head of U.S. retirement at Pacific Investment Management Co. LLC, Newport Beach, Calif., which has worked with clients to develop custom target-date funds. “We want to bring that same capability in prepackaged form to all plans.”

In May, PIMCO introduced its RealPath Blend target-date series, which features an average 60% equity/40% fixed-income ratio. All of the equity is passively managed by Vanguard Group Inc., and all of the fixed income is actively managed by PIMCO.

For Principal Financial Group, the decision to introduce a mutual-fund target-date series using a blend strategy — the Principal LifeTime Hybrid Series — in 2014 was based on plan executives' and participants' concerns about risk and fees emerging from the economic crisis of 2008, said Jeffrey Tyler, lead portfolio manager for Des Moines, Iowa-based Principal's target-date series.

Principal also has offered the actively managed mutual fund-based Principal LifeTime series since 2001.

Blend-strategy funds aren't new; the oldest one listed in Morningstar Inc.'s database was launched in 1996. But they still are significantly outnumbered by actively managed target-date funds analyzed by Morningstar, and there are slightly more blend funds than passive funds.

(The Chicago-based investment research firm defines an active target-date fund as one in which at least 80% of the underlying assets are actively managed; a passive fund has at least 80% of the underlying assets in index investments; and a blend is anything else. Morningstar doesn't track custom or collective investment trust target-date portfolios. Its research covers target-date funds used in retirement accounts and taxable accounts.)

Recently, several new blend-style target-date funds have entered the market. Product providers are trying to capitalize on the continued popularity of target-date funds in DC plans, especially as the adoption of such funds is propelled by their role as qualified default investment alternatives.

Still, all new target-date funds face challenges. The mutual fund-based target-date market remains dominated by three firms — Fidelity Investments, Vanguard and T. Rowe Price Group Inc. They had a combined 71% of the $703.4 billion in assets in 2014, according to Morningstar.

The struggle for new target-date funds to sustain growth is compounded by the fact that there is little long-term difference in performance among passive, active and blended target-date funds.

A recent Morningstar report showed that for the three years ended Dec. 31, the annualized total return, net of fees, was 11.7% for passive funds, 11.6% for active funds and 11.6% for blend funds. For the five years ended Dec. 31, the annualized return, net of fees, was 9.1% for passive, 9.1% for active and 9.3% for blend funds.

PIMCO decided to offer a blend target-date series in part because of DC plan executives' desire to reduce overall fees, and using passive equity helped bring down the cost, Mr. Fulford said. “Most clients prefer active fixed income and passive equity.”

The average expense ratio for PIMCO's blend target-date series is 28 basis points compared to the average expense ratio of 64 basis points for the actively managed RealPath series that has been available since 2008. The glidepaths for both series are the same.

The most likely market for the blend target-date series is a DC plan with $1 billion or less in assets, Mr. Fulford added.

In preparing its blend strategy, Principal assessed why DC plans might not want to go all passive despite the lower fees. “We wanted to add value where it made sense in going active,” Mr. Tyler said. Thus, high-yield bonds made sense as an active component while large-cap domestic equity didn't, he added.

The glidepaths for Principal's actively managed series and the hybrid series are similar.

“What distinguishes them is the expense ratio,” Mr. Tyler said. The average expense ratio is 70 to 80 basis points for the actively managed series. The average expense ratio is 40 to 50 basis points for the hybrid, whose allocation is about two-thirds passively managed investments to one-third actively managed investments. (Since 2009, Principal also has offered a collective trust target-date series whose average expense ratio is 33 to 39 basis points. Its allocation is two-thirds passive vs. one-third active.)

Other actively managed components include international equity, real assets and emerging markets debt and equity. All U.S. equity is passively managed, and so is a core U.S. fixed-income allocation. “The hybrid target-date series uses multiple managers and is considered open architecture,” Mr. Tyler said. “We look at every (asset) class on an annual basis.”

AllianceBernstein LP, New York, is pursuing DC plans with $100 million or more in assets for its new collective trust-based target-date series, featuring a 60% active/40% passive allocation, said Richard Davies, senior managing director for defined contribution.

The blend strategy focuses on passive investments to reduce overall costs and active investments to “take advantage of asset classes which are less efficient and where active managers have a greater chance to add value,” he said.

The AB Multi-Manager Retirement Trusts, introduced in June, feature a glidepath design by AllianceBernstein, which also is responsible for half of the active management component. Mercer provides manager research. Mercer also selects the rest of the actively managed investments and all of the passively managed investments. Thirteen managers are in the initial design.

The expense ratio is 45 basis points for DC plans with a minimum of $25 million in target-date assets and 40 basis points for plans with target-date assets of more than $250 million.

Mr. Davies said AllianceBernstein's experience with custom target-date funds and the collective trust target-date series' use of multiple managers offer potential clients a more flexible approach than that offered by a single-manager target-date fund series.

“Some plans are not big enough to go custom, or they don't have enough staff,” said Mr. Davies, whose company is the investment manager for more than two dozen DC plans using a custom target-date portfolio. “We're absolutely trying to take that custom knowledge and using it in the collective trust target-date solutions.” n