Which is better, an active or passive target date fund?

Actively managed and passively managed target-date funds produce similar investment returns over longer time frames, new research shows.
This research comes as target-date funds play an increasing role in defined contribution retirement plans and as plan executives debate which is the most appropriate approach. But investment consultants to DC plans say the research likely won’t greatly affect that debate.

RETURNS ROUGHLY EQUAL
For the three years ended Dec. 31, the annualized total return, net of fees, was 11.7% for passive funds and 11.6% for active, according to investment research firm Morningstar Inc.
For the five years ended Dec. 31, the annualized return, net of fees was identical, at 9.1%. Returns of target-date funds that blend active and passive management were similar to the other funds — 11.6% annualized over three years and 9.3% for five years.
(Morningstar classifies an active fund as having 80% or more of assets actively managed and a passive one, 80% or more of assets passively managed. Many are 100% one way or the other. Blend funds have allocations that fall in between the extremes.)

4 Retirement Mistakes Investors are Making Now

Passively managed target-date funds appeal to DC plan executives for several reasons, consultants said, including a desire for lower-cost options, a belief that there’s less manager risk and fiduciary risk, and a plan-management philosophy that favors passive over active. The Labor Department’s regulations increasing fee-disclosure requirements between providers and sponsors, which took effect in mid-2012, played a role in making executives more sensitive to costs and more willing to choose a passively managed approach, consultants say.
NO QUICK CHANGES
“One or two performance observations at the universe level shouldn’t lead sponsors and consultants to change their views on the optimal mix of active and passive in target-date funds,” said Christopher Lyon, a partner at the Norwalk, Conn.-based Rocaton Investment Advisors, when asked about the Morningstar data.
“More attention should be paid to whether a plan has the right glidepath, and then the right implementation, and less attention to backward-looking peer universe comparisons that typically have many shortcomings,” he added.
Among Rocaton’s DC plan clients, a “significant portion” chooses all-passive or mostly passive target-date funds, and the major reasons are lower fees and a belief in less manager risk, he said.
However, Mr. Lyon predicted that, in the next three to five years, some plans with all or mostly active funds and some using all or mostly passive funds will be “moving toward the middle,” seeking a broader mixture of components and investing styles within the funds.
The primary reasons plan executives choose passive funds are lower fees and a wish for open architecture, said Preet Prashardefined contribution senior research analyst at Plan Sponsor Advisors.
When asked about the Morningstar results, Mr. Prashar said “many plan sponsors prefer higher-fee, active target-date funds as they believe that active is able to provide a more diversified asset allocation, which can potentially help get better risk-adjusted returns over a full market cycle net of fees.”
The funds analyzed by Morningstar had $703.4 billion in assets as of Dec. 31, 2014. Custom target-date funds and collective trusts were not included in the research. Morningstar’s analysis covers mutual funds and exchange-traded funds, and incorporates target-date funds in retirement and in taxable accounts.
Actively managed funds dominate the roster of those counted by Morningstar: 32 active vs. 10 passive and 12 blend at the end of 2014. Actively managed assets in all types of target-date funds reached $465.1 billion last year, or nearly double the $238.2 billion of passively managed assets.
Although the growth rate has been greater for passively managed assets, they have “entered a more mature growth phase,” and the rates for each strategy have narrowed in recent years, said Janet Yang, director of multiasset class research for Morningstar.
“Many plan sponsors who believe in indexing have already moved there.”

COST MYTHS
Also, there’s no guarantee that a passively managed target-date fund will be the least expensive choice. Morningstar found a handful of passively managed funds whose expense ratios were higher than those of some actively managed ones.
“It can be a myth that all active funds are more expensive,” said Lori Lucas, the Chicago-based executive vice president and defined contribution practice leader for Callan Associates, adding that passive funds don’t always meet plan executives’ goals.
“Passive may not incorporate all asset classes for diversification. A passive glidepath may not be suitable for a (specific DC) plan.”
Annual Callan surveys show the primary reasons for choosing passive funds are clients seeking lower fees, low-cost qualified default investment alternative options, and a “perceived lower fiduciary burden,” Ms. Lucas said. Given those reasons, Ms. Lucas said she doubted the Morningstar research would change the thinking of DC plan executives who favor the passive approach.
The Morningstar data is “one piece of data at one point in time (which) should inform the debate — but not drive the conclusion,” said Jordan Nault, a Chicago-based principal at Mercer.
The data “does support the notion that investment manager selection in the active management space is extremely important,” said Ms. Nault, chair of Mercer’s target-date fund strategic research team. “It also supports stronger consideration of a blended approach.”
Mercer’s research shows actively managed target-date funds still dominate on an AUM basis, but passively managed funds continue to chip away, she said.
The primary motivations for DC plans choosing a passive target-date fund are expenses and the presumption of reduced fiduciary risk.
“We definitely saw a move into passive in recent years,” said Jacob O’Shaughnessy, an adviser at Arnerich Massena Inc. in Portland, Ore., citing the impact of the DOL fee-disclosure regulations, providers’ introducing new passive funds and plan executives’ seeking less fiduciary risk.
“There was a lot of low-hanging fruit to be taken by passive managers,” he added. “The initial wave of passive has passed by.”
Robert Steyer is a reporter at sister publication Pensions & Investments.