More Scrutiny for Target Funds in New Ratings

By now, the problems with target-date funds have been well-chronicled: The funds designed for people close to retirement lost as much as 41% when the market crashed, leaving those would-be retirees scrambling to make new plans. Burned investors cried foul play, and Congress, the Department of Labor and the SEC have all pledged to put the funds under a microscope.

But now a real power broker has weighed in. Fund rating company Morningstar (MORN) provides data and analysis to 401(k) plans, fund companies and financial advisors, announced at its annual investment conference Thursday it has created a method for evaluating – and scoring – target-date fund families. In the next few months, starting with the 20 biggest target-date fund families, Morningstar will grade the funds based on their management, investment process, performance, cost and the quality of the underlying funds that make up the portfolio. Because most of the money in target-date funds comes through 401(k) plans, the reports are mainly geared toward 401(k) plan sponsors, but a shorter version will be available on Morningstar’s web site.

A draft report presented Thursday (without the scores) looked at Fidelity’s $60 billion family of Freedom Funds. The reports aren't perfect: Like Morningstar’s fund ratings, these score the funds based on relative measures of performance, which means that equity-heavy funds will look better during market rallies, and more conservative fund families will shine when the market crashes. But they have also included some telling metrics, in particular what’s called an “attribution analysis,” which explains how much of the funds’ performance is due to asset allocation, how much to specific fund selection, and how much to a cost advantage. The draft analysis of Fidelity’s funds shows that the firm’s relatively conservative asset allocation added 2.6 percentage points to the return – not bad, until you consider that the underperformance of the funds in the portfolios robbed investors of more than three percentage points. “The Fidelity funds would have done better if they’d invested in index funds over the last three years,” said John Rekenthaler, the vice president of research at Morningstar.

Scores, ratings, and yes, comments like those, ought to shake up the fund world. Better late than never: For the last year SmartMoney has been calling attention to the fees and performance problems with target-date funds. As it is, Morningstar wields tremendous influence: Fund companies advertise favorable Morningstar ratings, a number of studies have shown that the firm’s “star ratings” affect fund flows, and 401(k) plans rely on Morningstar’s data and analysis as well. None of this is lost on Reckenthaler, who suggested that the biggest problem with target-date funds wasn’t their performance, but the variation among fund families, and the fact that investors just didn’t understand what they had. Morningstar’s analysis might help prevent those kinds of surprises, he said: “And then we won’t have congressional hearings, the DOL and the SEC asking ‘What happened?’”

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