January 31, 2012
In the second part of her paper, Sandhya examined different types of TDFs. She compared single-fund TDFs (SFs), which invest directly in stocks and bonds, to funds-of-funds, which invest in other mutual funds. She subdivided the funds-of-funds into those that invest in the parent company’s funds (internal FOFs) from those that invest in funds outside the family (external FOFs). All mutual funds carry the potential for agency problems, but funds-of-funds are more problematic because a second agent is involved.
She found that internal FOFs underperformed SFs by 58 (132) basis points and external FOFs by 55 (63) basis points based on risk-adjusted net-of-fee (gross-of-fee) performance. Sandhya believed that this reflects the fact that internal FOFs have the greatest potential for agency problems, and, while she did not pinpoint the exact mechanism of the underperformance, she offered two possible explanations. Fund companies might chose underlying funds with higher expense ratios, in order to maximize their revenue. Or they might include funds with poor performance, in order to sustain those funds, which might be otherwise unmarketable.
Indeed, in the next part of her paper, she found that funds with higher expense ratios or lower performance have a greater probability of being included in an internal FOF than in an external FOF. Moreover, within a fund company, internal FOFs tend to own funds with higher expense ratios and lower performance.
Sandhya’s evidence of agency problems in TDFs is very troubling. But the problems with TDFs are not limited to those that Sandhya cited.
Many TDFs have an opaque structure, particularly for SFs. It is often very difficult, if not impossible, to determine how much an investor is paying for the implementation of the glide path, as opposed to the actual management of the assets. Implementing a glide path should cost no more than a few basis points; if glide-path fees are significantly higher than that, investors or advisors should do their own asset allocation. Information on glide paths is publicly available, and annual rebalancing should be sufficient to maintain an acceptable asset allocation.
Moreover, TDFs are vulnerable to performance-chasing. As with any actively-managed fund, an underperforming manager might chose to increase the risk in his or her portfolio; an outperforming manager might chose a more conservative approach, such as closet indexing, to avoid any losses.
Finally, there is one crucial consideration that Sandhya’s paper does not mention: TDFs are only appropriate if they are the sole vehicle for an individual’s retirement savings; they are inappropriate for investors who also own stock or bond portfolios.
If you want to use a TDF, chose one that is low-cost and highly transparent, and make sure that you understand how much you are paying for the glide path. If that fee is too high, you should do your own asset allocation. Similarly, if you can’t figure out how much you are being charged for the glide path, it’s probably not a good fund.
Because of their complex structure, TDFs are more vulnerable to agency problems than ordinary mutual funds. Further research will be necessary to confirm Sandhya’s results over longer time periods and to identify additional agency problems that may be adversely affecting investor outcomes.
Nevertheless, Sandhya’s research is an important step toward understanding just how severe those problems may be. Advisors and plan sponsors should take notice.
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