Looking Under the Hood

Investigating whether life cycle funds are firing on all cylinders

They're one of the most popular investment vehicles for retirement, and yet despite their ever-growing appeal, there is little information in the market about life cycle funds and how they compare to other families of funds.

Obviously, this is in part due to the fact that life cycle funds are a new category and there is no real historical data yet available to measure their performance. But getting into the nuts and bolts of life cycle funds, how they are put together and managed, how they compare to their peers, as well as gauging their ability to deliver on their promised mandate is extremely important, says Joe Nagengast of Marina del Rey, California-based Turnstone Advisory Group, particularly as these funds represent an increasingly large share of 401(k) assets, and IRA owners are also setting their sights on them.

Turnstone has taken the first step toward providing the retirement finance market with a comprehensive study on the major life cycle funds available today. The recently released study, entitled Popping the Hood, essentially aims to find out to the extent possible whether life cycle funds are really delivering what investors expect of them, Nagengast says.

Turnstone took the major life cycle (or "target maturity," as the firm refers to them) fund families in the market today--Vanguard, Principal, Fidelity, T. Rowe Price, Barclays Global I and Wells Fargo--and compared their performance, allocation, equity characteristics, fixed-income characteristics, structure and composition, and risk characteristics. Every fund family was scored on each of these measures and assigned a weighted total score and ranking.

While there are probably close to 1,000 life cycle funds in the market right now, Turnstone narrowed their sampling down to those funds that had five years of performance history as of June 30, 2005. This would have eliminated Vanguard and T. Rowe Price, but the firm decided to include them because they have substantial assets under management, as do the other four families that were analyzed.

The study is just the first part of a work in progress, Nagensgast says. "The core of our risk analysis in this research was to analyze the risk of these funds through traditional portfolio management theory statistics, such as standard deviation, beta and so on," he says. "We compared the performances of the fund families in up and down markets, but that is not enough for a thorough analysis. To really make judgments about the inherent risks of these funds, you have to step out and look at other factors influencing their performance, and we will do that in the second edition of our study, to be completed early next year."

Thus far in the analysis process, Turnstone's main concern is that life cycle funds do not adequately address the risk of loss, Nagengast says. These funds rely on the return to the mean of performance to protect investors, which basically rests on the premise that if they are down for a few years, they will eventually come up. However, that is inadequate for investors who are looking at these funds as a life-long, long-term investment proposition, he says.

"These funds have looked at diversification and portfolio placement along an efficient frontier to address risk, but we think that that's not enough because both in the short-term and the long-term, it procures risks to end users," Nagengast says. "The rationale behind the mean variance analysis used by target maturity funds is that even if you lose in the short-term, you'll come out okay in the long-term. But the problem for an individual investor is that the benefits might not coincide with their retirement date, so while this premise works in theory and in the aggregate, it does not work for an individual."

Many experts have been pointing to this problem, Nagengast says, and are thinking up ways in which to address it. Turnstone will also be offering some pointers in the second edition of its research, as well as focusing more upon the key issue relating to life cycle funds, which is the fiduciary responsibility they have toward individuals.

"An investor in a 2020 fund will believe that he or she will have enough money at that time for their retirement. There is no promise of this, yet it is implicit," Nagengast says. "When these funds form part of a qualified retirement plan, it seems a fund manager has an even greater level of fiduciary responsibility--perhaps not legally, but in this case, falling back on absolute legal standards is not enough."

Popping the Hood is directed toward plan sponsors and financial advisors serving the defined contribution market, as well as toward financial advisors with individual clients that are thinking about life cycle funds, Nagengast says. It is available at www.turnstoneag.com.

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