Actively managed TDFs are getting edged out

Passively managed target-date funds are sucking the life force from their actively managed counterparts.

The money flowing into passive TDFs — those that invest primarily in funds that track a broad market index like the S&P 500 — has increased dramatically over the past few years as cost-conscious investors and 401(k) plan sponsors have sought out lower fees.

Last year, nearly all — 99% — of the $55 billion in net flows to target-date mutual funds went to funds holding at least 80% of their assets in index funds, according to Morningstar Inc. That left virtually no new money for TDFs that invest primarily in actively managed funds.

By comparison, in 2017, 95% of new money flowed into passive TDFs; the year prior, that figure was much lower, with index funds capturing roughly two-thirds of flows. Prior to 2012, active TDFs generally received more new money than passive funds, according to Morningstar.

“The demand is not necessarily for index funds, per se. It’s more so the demand is for lower cost,” said Jeff Holt, director of Morningstar’s multi-asset and alternative strategies team. “One of the ways you get the lower cost is via index funds. That’s what’s really driving the appetite.”

(More: 10 things to know about TDFs)

A number of things have driven 401(k) plan sponsors and their advisers to become more sensitive about investment fees. For example, the Department of Labor issued fee-disclosure regulations in 2012. A few years later, the agency released its fiduciary rule, which put fiduciary duty squarely into focus, as did a slew of lawsuits targeting employers over excessive fees in their retirement plans.

In addition, cost is one of the easier aspects to analyze when it comes to TDFs, which are “fairly complex” investment vehicles, Mr. Holt said.

Vanguard Group, known by investors and advisers as a low-cost provider of index funds, has benefited hugely from the trend. The firm’s target-date mutual funds received nearly $41 billion of new money last year — 75% of the industry’s overall flows.

Vanguard controls 40% of the TDF market, with around $650 billion in its mutual funds and collective investment trust funds, according to Morningstar, which released its annual TDF report Thursday. Its next closest competitor, Fidelity Investments, has less than 15%.

“Vanguard’s market share is pretty jaw-dropping,” Mr. Holt said.

Of course, there were some bright spots for active managers. American Funds and J.P. Morgan, for example, have both increased their market share over the past five years even though neither offers a series investing primarily in index funds, Morningstar said. American Funds saw $21 billion of TDF inflows last year and J.P. Morgan $1.2 billion.

Plus, the marketplace is responding to investor demand, with many firms debuting their investment strategies in a CIT vehicle or offering TDFs with a greater blend of index funds, which typically come with a lower cost.

Actively managed target-date mutual funds still hold more assets overall than passive TDF series — $570 billion versus $480 billion. Given recent trends, however, index TDFs will likely overtake active funds within a couple of years, according to Morningstar.