Assessing Asset Allocation Funds: 401(k) Advisor's Scorecard' Aims to Aid Fiduciaries
August 20, 2007
So-called target-date and target-risk asset allocation funds portend to make investing easier for 401(k) participants, but the proliferation of these products in recent years can make choosing which to offer a headache for sponsors.
According to the Investment Company Institute, there are more than 400 asset allocation funds with more than $300 billion in assets. Target-date, or lifecycle funds, saw a 50% increase in flows in 2006, compounding the 57% increase the year before.
Nearly all of these assets-91%-streamed in from retirement accounts, such as 401(k) plans. If asset allocation funds are, in fact, dubbed the default investment of choice for automatic enrollment in accordance with the 2006 Pension Protection Act, the growth and market influence of these funds will only increase.
Yet comparing them is tricky, because no two funds are built alike. Two 2030 funds, for example, might have vastly different asset allocations, glide paths and completely different underlying funds.
"Everyone's aware that we're comparing apples to oranges here," said Lynette DeWitt, a senior research analyst at Financial Research Corp. in Boston.
The comparison gets even more complex over time if the funds, or their underlying holdings, change managers or strategies, dramatically shifting their direction as years pass. Such attributions make them unique among funds in that two funds with ostensibly similar objectives-to allow an investor to liquidate at a retirement date of 2040, for example-are extremely difficult to accurately benchmark.
"These are truly dynamic," said Ron Bush, managing principal at Retirement Research.
That's not to say there is no interest in evaluating these funds vis-a-vis their competition.
"There is a real marketplace need for something," said Bush, who added that the system would have to be simple, reliable and most importantly, credible.
401(k) Advisors, a retirement consulting company in Aliso Viejo, Calif., believes it has devised just such a system to help fiduciaries, the industry's primary gatekeepers, to differentiate between existing funds and choose those most appropriate for participants.
Unlike rating systems available from Chicago-based Morningstar or Dow Jones in New York, 401(k) Advisor's Scorecard does not rank funds against one another; rather, the system runs on a one to 10 ranking system, assigning each fund its own score.
"When these funds first came out, because of the type of due diligence we employ, we made it quite clear to the clients we deal with that there is no great way to benchmark these funds," said Jeff Elvander, the company's chief investment officer.
"The peer groups are ill-defined, and in some cases, there are not enough peers in a group to make the analysis relevant," he said.
Scoring is 80% quantitative analysis, including performance and holdings, and 20% qualitative, gauging things like expenses and service. To tackle the issue of future shifting allocations inherent to these funds, the Scorecard uses a standard deviation calculation meant to measure performance risk, rather than compare performance to industry sectors.
Funds with scores over seven are considered "favorable," while those that earn a four or lower are tagged "poor." Funds that earn a five or six, Elvander said, would be put on a watch list, and fiduciaries would be encouraged to monitor their performance and future scores.
Already, 401(k) Advisor has scored 80 funds, favoring those with a track record of five years or more. According to the company's analysis, only 40% scored seven or better-including some perfect 10s-and 20% earned "poor" ratings.
For fiduciaries, having such a scoring system not only helps weed out the unattractive options, but also helps to document the decision making process that buttresses the plan's architecture. Even if funds are on a watch list, sponsors can document the reasons for their choices, and their understanding of the products' potential shortcomings.
Monitoring the scores over time helps plan sponsors prove their continued diligence, and defend their decisions to keep or change options as the score changes, Elvander said.
"What this score tries to accomplish is to identify the superior lifecycle and lifestyle funds," he said. "It gauges whether a manager adds skill or value."
"I don't know whether it would pass muster in terms of fiduciary responsibilities as a standalone factor in determining whether to select or to keep a fund, but it might be one of many due diligence efforts," said Luis Fleites, vice president and director of retirement markets at FRC.
Elvander said that so far, the plan sponsors he works with have received the system well. In some cases, poor-rated funds have even shifted course after seeing their Scorecard report.
But the system still faces some stumbling blocks.
"A very useful, well designed indexing or weighting system that doesn't have a name behind it is going to have a problem," Bush said, comparing 401(k) Advisors to 800-pound ratings gorilla Morningstar. "That credibility is critical," he said.
Another challenge is keeping up with the increasing number of funds. 401(k) Advisor's preference for funds with five-year track records severely limits the ever-increasing universe of such allocation funds. Fund companies like the set-and-forget message behind these funds, because it lends to automatically sticky assets, Bush said. The rollout rush that has preceded the Department of Labor's anticipated approval of these funds' suitability as default investment options has meant a flurry of new funds.
"[The rating on 80 funds] is a very, very limited universe," Fleites said, noting that mainly product pioneers, including Fidelity, Barclays and Wells Fargo are likely to be rated for a while, leaving a universe many times larger unscored.
DeWitt believes 401(k) Advisors is just the first in a coming wave of systems to evaluate target-risk and target-date funds.
"It will be quite a while before we have an industry standard," DeWitt said. "Someone has to develop a metric that can be a benchmark everyone can bounce against," she said. "It's great 401(k) Advisors has started the discussion."
(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.