Target date funds require careful selection

By Kate McCaffery | October 02 2011 04:17PM

Advisor interest and their intuitive appeal to clients appear to be keeping target date fund sales on track.
According to the Investment Funds Institute of Canada (IFIC), target date portfolio gross sales totaled $79.3 million in August 2011. (Gross redemptions totaled $38.1 million during the same period.)

Data from research firm, Investor Economics, meanwhile, shows that target date or life cycle programs held $5.5-billion at the end of June 2011. The Fidelity Clear Path portfolios and the BMO Life Stage programs combined held $3.2-billion ($1.7-billion and $1.5-billion, respectively.) In third place, the RBC targeted education plans have $840-million.

This interest is probably happy news for the companies offering target date funds. Like other fund of fund programs, the assets invested tend to be “stickier,” thanks to the fact that the products show clients an overall return number that is generally less volatile than returns in the underlying funds themselves.

Focus on relationship

Proponents say the products make sense, particularly given that it’s more widely accepted now for advisors to focus on relationship rather than portfolio management. More people are also beginning to agree that a team of mutual fund company managers might be better equipped to create generic asset allocation and optimization strategies than for a single advisor to try doing the same thing across multiple client accounts.

Advisors who sell the product also don’t need to explain changes every time a fund closes, gets merged or does poorly. A client who isn’t seeing multiple statements each month, including those from funds that might not be doing so well at any given time, is also less likely to be spooked into selling out of a diversification strategy during periods of volatility or downright poor performance.

“A target date (fund) is a very valid option in many, many cases,” says Carlos Cardone, senior consultant and managing director at Investor Economics. “Target date funds have pros and cons like every other fund product. I think you can certainly find a lot of situations in which target dates are a really good solution.”

The funds do not escape without their fair share of criticism though.

There is the concern that target date funds encourage a “set it and forget it” mentality among advisors and investors. There is also a question of suitability if clients don’t know precisely when they’ll be retiring.

A client who decides they may need to work longer than initially anticipated, for example, would need to sell out of their target date portfolio in its entirety if they wanted to regain a little bit of equity exposure, which can result in unnecessary tax consequences.

Weaknesses highlighted after 2008 also suggest some guaranteed product variations are not the most effective to have and hold during times of extreme volatility, when losses can trigger the funds to revert to cash, usually when markets are at their lowest, in an effort to protect principal guarantees.

“The guaranteed target date funds, I have no use for,” says Dan Hallett, vice-president and director of asset management at Highview Financial Group. He adds that he would rather see a client invested in a balanced fund with a GIC used to manage risk instead.

“While buying a fund with a time horizon which lines up with your client’s investing horizon has intuitive appeal, it’s nothing more than a short-cut solution wrapped up in marketing fluff,” he writes. “An investor’s asset mix should be driven by future spending targets (i.e. liabilities). Once those future liabilities are clearly defined, with associated time frames, the investor’s assets can then be invested to ensure that assets are well-matched to those liabilities.” Target date funds, he says, consider time horizons alone, without much regard for the liability matching and other variables. “It’s a short-cut,” he says. “Guarantees simply worsen an already mediocre product.”

Even those who do like the product express similar concerns about certain “guaranteed” products.

Although it is very much a function of each individual product, “there are certainly risks associated with principal guarantees,” says David O’Leary, director of fund analysis at Morningstar Canada. “I have a big problem with that,” he adds, speaking about the funds which simply sell assets before the fund loses money. “I don’t think that’s a principal guarantee at all. If all they’re going to do is sell off your investment before it loses money, it’s not a guarantee.” (The same, he says, can be done with a stop loss order through a discount brokerage.) “If the thing does lose money and the bank steps in and says, okay, we’re going to make you whole, that’s a very different thing than saying we’ll just sell your investment before it loses money.”

To compound the problem, some funds are structured such that investors can’t benefit from any rebound and, in some cases, can’t even access their cash once the fund has monetized until the product’s term runs out. Not only are clients pushed out of any exposure to upside gains, “they’ve sold you off, really, at the worst possible time,” he adds. “It’s a sell low strategy.”

In addition to looking at the ways certain guarantees are achieved, if applicable, there are several other components to look at when picking the products as well.

Evolution in the channel have some companies creating more than one asset mix for each fund in order to cater to different client risk tolerances.

Target date ETFs

Target date ETFs are also in development. As well, where one product will be constructed using a company’s own funds, others will hire consultants to create programs made up of third-party manager funds.

It’s worth examining which underlying managers the fund has selected for inclusion (the analysts suggest reviewing this lineup annually) and, like any other mutual fund product, they say clients and advisors should have a close look at fees. “Bonds and cash, if they’re not a big component today, they will be at some point,” says Mr. Hallett. “Fees become important whenever you’re looking at a structure that has a significant bond and cash component.”

Although some funds advertise declining MERs to reflect this change over time as one of their selling points, oftentimes the decrease is less than 15 basis points.

“There’s a lot to evaluate,” says Mr. O’Leary. “It’s funny because they’re meant to take a lot of work out of the hands of the investor, the advisor, but in order to properly pick one there’s a fair bit of work involved.”

BY Kate McCaffery