Dr. Swensen Speaks and His Bottom Line: Don't Try to "Be Like Yale"

David Swensen, head of Yale Investments gave an extensive interview to the Financial Times He certainly displayed no remorse over his investment strategy. Yet at the same time he advised (as he has done before) that most investors both individual and institutional are far better off pursuing an investment strategy utilizing liquid,transparent index funds and etfs.
My bolds and italics.

Lunch with the FT: David Swensen
By Chrystia FreelandPublished: October 8 2009 18:50 | Last updated: October 12 2009 17:18

For almost one-quarter of a century, David Swensen, head of Yale University’s $16bn endowment, has been one of the most influential figures in US finance. Because of his extraordinary success in managing the Yale fund, Swensen has been described as the biggest “donor” in Yale’s history.

...Swensen commands more financial firepower than most of the more gilded combatants on Wall Street, just a 90- minute train ride away. In the 10 years to June 30 2008, Yale’s endowment fund posted average annual gains of 16.3 per cent, including banner returns of 41 per cent in 2000 and 28 per cent in 2007. It is a performance that has had fund managers clamouring to look after Yale’s money (like most big endowments, Yale entrusts most of its wealth to outside money managers). A Swensen investment became one of Wall Street’s most coveted seals of approval.
Swensen’s approach transformed the management of university endowments and other big public funds, inspiring them to follow his strategy of shifting from putting all their money into traditional investments in shares and fixed-income bonds, and instead moving partly into so-called alternative investments such as private equity or real estate. His investment style is so well-known – perhaps second only to the “value investing” approach of Warren Buffett – that it is often simply called the “Yale model” or the “Swensen model”....

The financial crisis and the sharp public censure that it provoked of Wall Street’s culture of excess and instant gratification was, in some ways, a vindication of Swensen’s Lutheran ethos of self-restraint and his philosophy of investing for the long-term. But the crash brought pain to Yale, too: in the fiscal year ending June 30 2009, its endowment was down 24.6 per cent, a wrenching $5.6bn investment loss for the university and an unprecedented setback for Swensen.
Swensen traces the origins of his career back to a precocious interest in capital. ..
Does Swensen feel he anticipated the crisis?


“Late in 2007, Yale took all of its operating cash and moved it out of money market funds and put it into Treasury bills, so we were absolutely aware of potential issues. And that was months before Bear Sterns,” he says. “But, that said, we weren’t prepared for the magnitude of the crisis, or its duration.”
This mild assertion of prescience in late 2007 makes me wonder whether the crisis has prompted Swensen to reconsider his big idea – investing in illiquid assets. If more of Yale’s assets had been easier to cash in at that time, surely Swensen would have moved more money into T-bills [ultra-secure US government bonds] and hence suffered a smaller loss? (Partly thanks to doing just that, the University of Pennsylvania’s endowment reported one of the smallest losses in the year to June 30 2009, and fell by 15.7 per cent.)
Swensen has a monosyllabic reply to this speculation: “No.” I try again. Swensen is still terse: “No, we never would have done that.” I try a third time, but it isn’t until the fourth version of the question that Swensen offers a more expansive response: “There have been some articles that have criticised the Yale model and my role in managing the endowment. And I think that’s odd ... What’s the alternative? Aside from the heroic impossible alternative of being 100 per cent in T-bills?” Over the longer run, he says, Yale’s diversified strategy handily beats a classic 70/30 allocation in stocks and bonds.
The larger point, Swensen believes, is that even though moments of radical disruption, such as the 2007 financial crisis, reward investors who make a big bet on major change, “ultimately, market timing is an exercise in futility. When you’ve got dramatic movements in the markets you can identify after the fact a handful of investors that succeeded in the short run. But making big, aggressive asset allocation moves isn’t a strategy that’s likely to prove successful in the long run.”
Years of steady, exceptional performance have made Swensen an investing legend among the cognoscenti and largely insulated him against questions, such as these, about his investing approach. ...

Dr. Swensen is a far wiser and more experienced than I am but I am not sure the questions or the answer really probed the more important issues related to the Yale model. Those would include the issues of liquidity, leverage and transparency related to the alternative investment vehicles. After accounting for those additional risks was the portfolio adequately compensated relative to a portfolio of more liquid transparent instruments with no leverage ? Wouldn't a proper alternative (pun intended) portfolio to the Yale model be one that holds allocations of global stocks, commodities, and various types of fixed income through liquid and transparent vehicles such as etfs combined with a cash cushion to meet liquidity needs ? Dr. Swensen seems to acknowledge that such a strategy is probably best for most investors and he seems to argue that the best thing to learn from the Yale investment experience is how difficult if not impossible it is to replicate :

....He says the crisis has reinforced his view that the most important investing advice is “you should invest only in things that you understand. That should be the starting point and the finishing point.”
For most investors the practical application of this axiom is to invest in index funds (low-fee investments that aim to mirror the performance of a particular stock market index). “The overwhelming number of investors, individual and institutional, should be completely in low-cost index funds because that’s easy to understand.”
Even after the battering of 2007 and 2008, Swensen is not optimistic that many will follow his advice: “The investment community is hopeful – hopeful’s probably too weak a word – wildly optimistic about their particular chances ... Never underestimate the gullibility of large pools of money.”
Swensen says his criteria for selecting outside money managers are simple: “The most important thing is character and the quality of people. That’s also the second most important thing and the third most important thing. It’s everything.” Assessing character involves such deep background checks that, says Swensen, “Some of our managers will tease us about having tracked down their high school geometry teacher.”
Such basic research would have protected investors from the convicted fraudster Bernie Madoff, Swensen says: “If you sat down and had a conversation with him about his investment activities and couldn’t figure out that he was being evasive, shame on you.”

Searching For Alpha ? Don't Look For It in An Active Mutual Funds

Kudos to Morningstar for producing an in depth study of whether active mutual funds produce additional returns on a risk adjusted basis.

Despite the fact that Morningstar's core business is to review and rate actively managed mutual funds, one has to sit up and take notice when they reach the following conclusion (although I would hardly have expected them to come up with a different result from their research).

As the WSJ reported (my bolds and italics)

While it's been established that most actively-managed mutual funds lag their indexes over time, a new study further twists the knife: Active management suffers even more by comparison on a risk-adjusted basis.

The study found that in many cases where an actively managed fund beats its index on an absolute basis, the additional risk it took didn't justify the returns they earned. Not only should that be a warning sign for investors -- because greater risk means greater volatility -- but it also suggests that fund managers aren't living up to what's expected of them.

The study by Morningstar Inc. found that while about half of actively-managed funds outperformed their respective Morningstar style indexes over the past three years, only 37% did on a risk-, size- and style-adjusted basis. The numbers are similar for five and 10-year returns

Although few would enter into the strategy listed below, it makes perfect sense. Active managers have no consistent skill in outperforming the market yet charge for managing money much greater than and index fund. Therefore the most direct way to increase risk in the quest for greater return is to simply leverage up the index investment. Of course we know that leverage has other potential drawbacks but that is the subject that I have dealt with in outher posts.

The key to thinking of risk in terms of returns versus an index, he said, is that in theory if an investor wanted to take on more risk for greater returns, they could simply buy an index fund and lever up their exposure. That would also increase returns while adding risk -- and do so at cheaper cost to most actively managed funds. It's against this standard that actively managed funds should be judged, he said

Interestingly although I am certainly a skeptic of modern portfolio theory (MPT)
and the efficient market theory, in this case the above comment is both accurrate and consistent with that theory. If one believes, as I do, that the "weak form" of the efficient market theory is true = it is near impossible to significantly beat the market (the benchmark index) then the only way to reasonably hope generate excess return over the maket(index) return other than increasing risk through leverage.

Excuse the jargon but a portfolio composed of 100% of an S+P 500 index fund for example with 10% of the portfolio borrowed on margin and invested in the index would create effectively a 110% holding in the S+P 500. The portfolio would have an expected return of 1.1 times the index (both on the up and downside) and would have a beta (risk measure ) 1.1 or 1.1. times the risk of the S+P 500. No additional risk= no higher expected return.


Of course Morningstar's research guru can't articulate the logical conclusion from the study: ignore the idea of picking an active fund and stick to an indexed portfolio. Instead quite illogically he states:

Russ Kinnel, director of research at Morningstar, suggested investors looking for active management should head into the less risky funds.

"It's generally better to be in a lower risk fund," he said. "There's more consistency [of performance] and timing when you invest is less critical [in determining your returns]."

Human nature also plays a part, said Kinnel.

"It's harder for people to stay with funds that go up and down extremes," he said.

But Portfolio theory and the same logic that lead the Morningstar analyst to suggest that the most reliable way to avoid extreme fluctuations in a portfolio is not to try to choose less volatile actively managed funds. It is the mirror image of the
leveraged strategy described above. By increasing the % holdings of the risk free asset (tbills) and reducing the % holdings in the risky asset (the index
dex fund) one reduces the volatility of the portfolio along with the expected return.

So if investors understand their risk tolerance they can vary the percentage of their portfolio in an index fund (including leveaging to hold more than 100%)
with their holdings in risk free tbills as the most efficient and reliable way to manage risk and expected return

All of this is the bare bones of modern portfolio theory from Markowitz a basic concept that is pretty indisputable if you belief that alpha (excess reurn without excess risk) is not achievable on a systematic basis. The Morningstar study certainly seems to give evidence that alpha doesn't exist.

The full Morningstar study is here
Some other pointsiliom the study:

Over a trailing five year period the odds were about even that an active fund would beat a passive one in the 9 morningstar style categories.But for both 3 and 5 year periods active funds did not add returns on a risk adjusted basis (i.e. there was no alpha)

Excuse the geekiness but Morningstar used both the Jensen and the Fama French alpha. The latter gives a better measure of how much the fund outperformed the index,rather than generating excess returns by holding assets outside its category, (he style drift I have disucess before). Using the Fama French alpha only 37% outperformed on a risk adjusted basis vs. 41% for the Jensen measure. And the Fama French alpha does not fully capture the effect of style drift.

Cash holdings are consistent across funds in contrast to the oft cited claim of those touting active funds that unlike an index active managers will know when to raise cash by selling stock and when to reinvest.

One more interesting finding: larger funds have lower alphas illustrating the well known phenomenon of closet indexing particularly for large funds. But here is an interesting wrinkle to that fact: Investors are know to chase performance, so when they learn of a fund that has performed well recently (from Morningstar,cnbc or other parts of the financial press) they rush to invest in that fund often one with a small asset base. The assets go up the fund becomes a closet indexer and whatever short term alpha might have existed is gone. Investors are chasing both performance and perceived alpha based on past data. But the likelihood is that they will put assets into the fund just when its alpha measure goes down.

In Response to Samuel's Comment (and maybe this will help some other readers)

I do plead guilty to aiming the level of this blog above that of the novice investor, although I think they will find much useful here.

My objectives are:

1. Not to offer short term market commentary, individual stock recommendations or recommendations among active funds.

2. To reinforce the importance of implementing a well diversified portfolio of low cost instruments and avoiding attempts at market timing.

3. To debunk material from the industry and in the press that touts strategies that don't meet the above.

4. Commentary on evolving trends in academic finance as it applies to investment portfolios.

5. Since I teach a course in investment management for not for profits, I have a special interest in that area and do comment on it. The recent developments in this area btw have great relevance to the overall investment world.

Despite the large number of books that tout the strategies I disagree with, there are a number of good books that at least provide the logic behing the "plain vanilla" version of my approach. A couple recommendations:

anything on investing by John Bogle
the Gone Fishin' Portfolio by Alexander Green and his website
The Wall Street Self Defense Manual by Henry Blodgett
The Four Pillars of Investing by William Bernstein (a bit more advanced)

So to be honest my blog is aimed at those who are pretty comfortable with the content above and probably even the material that would be taught in an introductory finance class and probably someone that reads the money and investing section of the WSJ fairly regularly (and avoids CNBC and especially Cramer).

But please keep reading and post questions in the comment sections, I will try to respond

A Must Read

From the excellent Financial Times article on the future of investing:


A great review of the shortcomings of Modern Portfolio Theory and the quest for a nwew model.

Wanted: A New Model for Markets

An Interesting Example of A Different Way of Looking at Risk....and A Sign Hope Still Springs Eternal

The Financial Times (FT) has been running a great series on investing with one theme being the need for a new model. One theme in the articles is the idea which now (finally) seems to be widely accepted, that MPT (modern portfolio) and its partner the efficient markets theory, while elegant in academia have shown little correlation (pun intended) to what goes on in the real world of financial markets. As John Authers the excellent writer for the FT points out in one of the articles:(my italics and bolds)

In the past 10 years, these models have become much more sophisticated, as investors add new asset classes that appear to have a low correlation with equities or bonds. Most prominently, this has involved diving into commodities and currency trading. But it has also been popular to try out esoteric strategies used by hedge funds, that were designed not to correlate with the market, as well as highly illiquid investments in forestry or energy.
Last year this approach came catastrophically unstuck, as virtually all of these asset classes fell in unison. This was a disaster for institutional fund managers.
“The correlation between supposedly uncorrelated assets was higher in the up market and much higher during the down market than they had been led to believe,” says Amin Rajan, of CREATE Research of in Kent, southern England, who said that many institutions wanted to follow the trail blazed successfully by big endowments such as that of Yale University. “These models hadn’t been stress-tested. They went into it on the principle that these opportunities existed, and there was a first-mover advantage. But they had no governance structures and no skill sets to manage those risky assets.” Asset allocation previously proceeded on the assumption that correlations between different asset classes were relatively stable over time. One implication of the crash is, therefore, likely to be that the alternative asset classes, such as commodities, that gained favour because they appeared to have a low correlation with stocks and bonds could now lose popularity....

The article cites an interesting different way of risk proposed by Wells Fargo Asset Management I couldn't agree more:

.... of “alternative risk budgeting”, comes from Wells Fargo, a company that was in the forefront of developing modern portfolio theory a generation ago.
All look at the risk of outright loss, rather than the volatility of returns.
This requires asset allocators to look at nine different kinds of risk: concentration risk (the risk that many investors have crowded into the same strategy, making it more prone to sudden busts); leverage risk (which multiplies both gains and losses); liquidity risk (the chance that an asset cannot be sold quickly at the prevailing price); transparency risk (if the investment structure is too complex to understand, Wells Fargo suggests, it is too risky); sensitivity to the overall equity market, and bond market; event risk (the danger an unforeseen event could pose); volatility risk (the extent to which returns vary); and operational risk, which includes various risks of businesses failing to perform.

The article mentions as "similar" the following approach from Pimco. I find far less substance to the Pimco approach but more on that in a future post.

Mohamed El-Erian, head of the large bond management group Pimco, suggests that asset allocation should be about the “risk factors” of different investments, rather than about asset classes. “The same risk factor can apply in different asset classes,” he says. For example, there is an equity risk factor in corporate bonds. “What makes this interesting is that it’s not just about the classic factors like equity, or default, or interest rates, or inflation or liquidity. There’s also a risk factor, which is public policy. Whether we like it or not, government has become an integral part of markets

I'm not quite sure what the above means...more later.

Mr. Authers is a very bright man yet even he falls into the camp of "looking for alpha" arguing that most of a portfolio should be indexed but that a small % should be allocated to "genius managers" Needless to say I agree with the former and strongly disagree with the latter.

Auther writes

Other changes are afoot. The steady shift towards passive investing (merely attempting to replicate a benchmark, rather than to beat it, and saving on expenses) is likely to stay intact. ....
There will also be a change in the way brokers analyse retail mutual funds, and the way pension consultants analyse institutions. Over the past 10 years the “style box” approach has predominated..... managers have skill, and then to give the truly gifted managers greater autonomy. Rather than “closet indexing” – staying close to a benchmark – the idea is that assets should be truly passive, or entrusted to managers with skill. ...
““You’ll see a move away from the practice of constraining managers and towards absolute returns, as opposed to relative nonsense.”

Ill have more to say in a future post about "absolute returns" funds which to me is a fad. Firstly few of these "absolute return" managers fared will in the recent crash, they proved to be heavy in leverage and illiquid assets. In fact they were high in virtually all of the risk categories listed by Wells (above).

So in my view the search for extremely talented go anywhere investors will prove no more successful than those within categories. There is likely to be little consistency in returns and in fact rather than having skill in a narrow niche of the market these absolute return investors must have even broader skills. As Naseem Taleeb writes in Followed By Randomness manager luck is often misinterpreted as skill.

Finally as the head of one of the largest absolute return managers writes, these managers will likely be more conservative going forward eliminating one of their major tools for outperformance :

Investors will also be more conservative, particularly when it comes to leverage. Clifford Asness, founder of AQR, says: “For the foreseeable future, I think people will be much more sensitive about getting into a leveraged trade. While leverage will still be a useful tool, all-else-equal, the smarter investor will always prefer the less leveraged trade, and more so going forward.”

I still feel that while MPT is oversold, a prudently diversified portfolio with passive vehicles is the best approach. Importantly it guarantees avoiding all of the key risk factors cited by Wells...somethin absolute return managers cannot assure/ Searching for "absolute returns" is just another word for the elusive quest of "searching for alpha". In my view absolute return funds are simply a fancy way of saying "we have a genius manager, trust us and give us your money to manage"...no thanks.

Stanford Goes For Liquidity...and Others May Have to Mark Down Their Portfolios

Stanford has decided to try to sell off some of its venture capital holdings in an effort to raise cash. As noted in the nyt today, this move could have wide expectations for its fellow university endowments.

First off, the move represents a further retreat from the "Yale model" which incorpates large holdings in alternative investments such as private equity, hedge funds, commodities, and real estate. As I have noted in earlier posts, the financial market's meltdown revealed several unanticipated aspects of the strategy. The alternative assets did not provide the desired diversification relative to conventional asset classes. Additionally, the consequences of the lack of liquidity in these altertaive asset classes meant that the endowments had to either borrow or sell more liquid assets to raise funds for current expenditures. Selling off the liquid assets of course would make the alternative assets an even larger percentage of the portfolio holdings.

Stanford's solution is to sell of parts of its private equity investments to third parties since it cannot liquidate the holdings with the private equity firms. As noted in the nyt article(below), the transactions are likely to be consummated at price levels far below reported values. Harvard reportedly shopped around some of its private equity holdings and balked after receiving bids for 50 cents on the dollar.

The potential sale raises some interesting questions:

1. If Stanford sells of some of its private equtiy holdings at deep discounts to their reported value will it be able to justify valuing its remaining private equity holdings without factoring in a discount to reported value ?

2. Even more evident, as noted in the article, are the consequences for other universities that hold investments in the same private equity firms. If Stanford has established that fair market value for the holdings is way below reported value, how will the other endowments justify not "marking to market" their holdings.

Although college endowments are allowed to value their assets at a hold to the maturity value will the trustees of these schools accept such a methodology. And even more important, should a University doing financial planning use an endowment value they know is way above market values.

Will Universities wind up using "shadow accounting" with internal planning based on an endowment value well below the externally reported value ? And what will the Univesities use in fundraising: a low number in an effort to indicate the importance of raising new monies (thus acknowleding larger than reported investment losses) or a higher number which would make the university look unrealistically financially secure.

Ironically the above issues are quite similar to the ones that arose when the major banks balked at selling off their "toxic assets" through some type of market mechanism. Once a market price is established it is difficult to argue that the whole asset class shouldn't be marked to market. And the dispute between mark to market vs another "fair value" (or mark to myth to the skeptics) as a method for valuation was a key feature of the debate over bank balance sheets.

my bolds my comments in italics

October 6, 2009
Dealbook
Investment Indigestion at StanfordBy ANDREW ROSS SORKIN

Stanford University is holding a garage sale....

During the boom times, Stanford Management, joined other endowments in a rush to plow increasingly large percentages of their funds into private equity, real estate and other illiquid investments — committing some $12.6 billion of the university’s endowment.

But then the market soured, and Stanford’s endowment lost $4.6 billion in value in its last fiscal year, a decline of 27 percent. So it now seems to be suffering from investor’s remorse.

Its plan to sell part of its stakes in private equity firms — a bid to raise $1 billion or more — appears to be an attempt to cut losses on current investments and a way to get out of committing more money to future deals....

Harvard, whose endowment shrank 27.3 percent last year, looked to sell some assets earlier this year. But given the lukewarm response, it struggled in a bid to sell about $1 billion of assets before pulling the sale. The California Public Employees’ Retirement System has been looking to sell, too....

Stanford isn’t planning to sell stakes in individual private equity deals. Rather, it wants to sell its place as an investor in private equity firms. (The funds, of course, won’t just let endowments out of their commitments.)....

.. it’s a rare chance to get a portfolio of this quality and of this size.”

Even so, Stanford’s decision will send a chill through the halls of endowment offices at other universities. By trying to sell such a large position all at once, Stanford will invariably depress prices for any institution considering a similar move....

it did,in fact, already take out an expensive $1 billion line of credit as a cushion in the event that it needed help keeping the lights on for students. Its decision, according to people who have been briefed on the university’s thinking, is a strategic one — it wants to reduce its exposure to future private equity deals.

But taking this step suggests that Stanford wants to distance itself from other endowments like that of Yale, led by David F. Swensen, who pioneered the push toward universities holding illiquid investments.

That strategy is often called the Swensen model. His fund has been decimated as well, falling $5.6 billion, or 24.6 percent, in the last year. (The average large university endowment dropped 17.2 percent in that period, according to the Wilshire Trust Universe Comparison Service.) But unlike Stanford, Mr. Swensen is not changing course and selling assets — at least not yet.

Stanford will be trying to sell to a group with some pretty hardball techniques when clsing deals:

When Stanford tries to sell its stakes in private equity portfolios, it will be entering a netherworld of secondary deals inhabited by a small cadre of investors looking to buy stakes on the cheap. They include AlpInvest Partners, Coller Capital, Credit Suisse, HarbourVest Partners, Goldman Sachs and Lexington Partners. The auction is being handled by Cogent Partners.

Nyppex, which tracks secondary deals, said that earlier this year such deals were made at 29.3 cents on the dollar, based on net asset value.

That number has moved up in recent months as confidence has returned to the markets, and Nyppex’s latest estimation indicates that recent deals have gone for an average of 51.58 percent of net asset value.

One question that has vexed the endowment industry is how to determine the value of portfolios. At the end of every quarter, private equity firms typically send out current valuations of their portfolios and the endowments accept them at face value.

But what happens if Stanford is able to sell its stake at only 50 cents on the dollar, for example, when K.K.R. is listing it at 80 cents? If other endowments hold similar stakes, what happens to their value?

This is still a hypothetical, because unlike investment banks, endowments don’t have to mark to market. Instead, they value their assets on a hold-to-maturity basis, which means they should not have to reduce the value of those portfolios in the short term.

But if things get worse, will they have to?Universities specialize in the art of big-picture questions. This probably isn’t one they want to contemplate.

Some Improvement in Target Funds...But I'm Still Not A fan

I have written several times about the problems with target date funds. The dismal performance and the large differences between the performance of funds with identical target dates provided quite a surprise for investors who perceived these as a safe and conservative investment vehicle.

It seems the fund companies are looking to rework these funds as well indicating they weren't ready for prime time when they came to market. And what is the revolutionary idea that these fund companies are coming up with ?.....more use of low cost index instruments. The funds still have many problems with regards to transparency of the "glide path" (the way the allocation changes as the target date approaches) and how they fit into an overall investment strategy. Seems to me that most investors are far better off with their own portfolio of low cost index instruments,

The FT today on changes in the target funds. My bolds my italics

Steep losses fuel growth of passive investing

By Marianna Lemann

Published: October 4 2009 10:07 | Last updated: October 4 2009 10:07

The long-running debate over active versus passive management has emerged in the target date fund market, where a number of active managers are turning to passive strategies.

Most notably, Fidelity Investments, the number one provider of target date funds in the US by assets, recently disclosed in regulatory filings that it is planning to offer an index fund version of its target date series, known as the Freedom Funds.

Fidelity is not alone. TIAA-Cref is also about to roll out an index version of its target date fund series and Schwab has boosted its allocations to index funds held within its target date series.

Meanwhile, Morningstar reports that firms like Seligman, Nationwide, State Farm, Barclays, AIM and DWS have more than 30 per cent of target date fund assets invested in passive strategies.

The growth of passive investing in target date funds comes as steep losses have fuelled scepticism about the value of active management within the funds....

Last year’s market turmoil revealed that many target date funds had a more aggressive allocation (known as the glide path) than investors may have expected, with many 2010 target date funds suffering double-digit losses. Those losses drove investors, plan sponsors and regulators to take a closer look at how these funds are structured, managed, priced and marketed.

As part of that review, cost has become a bigger issue across the mutual fund industry and is taking strong root in the target date marketplace, says Josh Charlson, a senior mutual fund analyst at Morningstar....


“The new funds will expand the products we offer our clients to help them create the best possible retirement-plan menu for their employees,” Ms Cohen says. “We believe active and passive target date funds offer clients important advantages – strong diversification and automatic rebalancing, in a convenient package.”

The lower expense ratios are also important, says Mr Charlson of Morningstar. Active management erodes performance by virtue of higher fees and adds an extra layer of risk to target date funds.

“In 2008 it became evident that even with a glide path you could end up with losses beyond what you might expect because of a blow-up in a core bond fund,” he says.

In fact, the Standard & Poor’s index versus active fund scorecard (Spiva) suggests the higher fees investors pay for active management generally do not result in better returns. The latest Spiva scorecard, which covers a five-year period ending June 30, shows the S&P 500 outperformed 62.9 per cent of actively managed large cap funds, 73.4 per cent of mid cap funds and 57.4 per cent of small cap funds.

“There is a trend towards indexing or passive investing in the target date space and it makes sense because target date funds are part of a long-term financial plan, generally encompass a large portion of an investor’s assets and have a long time horizon,” says Doug Dannemiller, a senior analyst with Aite Group. “You don’t need alpha to satisfy that goal, you can’t plan for alpha but you can plan for cost savings.”



“I wouldn’t be surprised to see a lot of firms having multiple target date offerings,” says Laura Pavlenko Lutton, editorial director at Morningstar’s mutual fund research group.

Of course morningstar with its vested interest in serving the interests of active mutual fund managers and creating a market for the analysis of such funds sees the perfect world as one of endless complications and high fees for investors::

“Maybe you’d have one with a conservative glide path or a more aggressive glide path or all index option or all active option. We are going to see a lot more niche target date offerings that have more of a specific mandate rather than being for everyman.”