Fund companies are tinkering with these one-stop retirement plans after their bear-market beating.
From U.S. senators to government regulators to shell-shocked investors, everyone, it seems, is drawing a bead on target-date funds for producing such rotten results during the 2007-09 bear market. These funds were supposed to be simple solutions for retirement saving: You picked a fund with a date close to your anticipated retirement. As the date approached, the fund would adjust the bond portion of its portfolio to become more conservative and protect returns.

But that’s not exactly how it worked. Take 2010 funds, for example, which were designed for investors at or near retirement now. On average, those funds lost 34% of their value during the bear market. That was still better than the 55% drop in Standard & Poor’s 500-stock index, but it was a big hit for investors in the critical first years of retirement.

And because each family of target-date funds has its own mix of assets — and follows its own so-called glide path when shifting to more-conservative investments — fund performance varied considerably. For instance, the worst-performing 2010 fund, Oppenheimer Transition, had 66% of its portfolio in stocks, plus a big bond holding that tanked. As a result, it posted a decline of 54%. But Wells Fargo Advantage Dow Jones Target 2010 had just 25% of its assets in stocks. It lost only 19% during the same period (see the table below).

Full disclosure

Those results prompted the U.S. Senate, the Securities and Exchange Commission and the Department of Labor to pile on with hearings investigating the use of target-date funds in retirement plans. Let us be upfront about where we stand: We have always liked target-date funds and still do, even when they invest aggressively (within reason) in stocks. Some lawmakers have pushed for regulators to establish asset-allocation guidelines for the funds. We disagree — that’s a job for fund managers. But investors do need to know what’s in these funds and how best to manage them as part of their overall investments.

That’s especially true because target-date funds are popular default options in retirement plans. If you don’t choose your own investments in a 401(k) plan, for example, your employer may deposit your contributions into a target-date fund. Congress permitted this with the Pension Protection Act of 2006, and since then the number of plans that automatically funnel 401(k) contributions into target-date funds has more than doubled. According to Vanguard, one of the three largest providers of target-date funds as measured by assets, the percentage of plans it manages that use these funds as default options grew from 42% in 2005 to 87% in 2008. Fidelity, another top target-fund sponsor, experienced a similar pattern in the plans it manages.

And target-date funds may blossom into something even bigger because younger workers are more likely to own them. Casey Quirk, a consulting firm, projects that money in target-date funds will grow 11-fold, to $2.6 trillion, by 2018. The firm assumes that target funds will attract 80% of the new money going into retirement plans over the next decade. At the end of 2008, 43% of retirement-plan participants in their twenties owned these funds, up from 29% in 2007, reports TD Ameritrade. That compares with just 22% of savers in their sixties.

But many investors don’t understand how target-date funds work. A recent study by Envestnet Asset Management and Behavioral Research Associates found that only 16% of investors had even heard of target-date funds. Of that group, 62% thought they would be able to retire when the fund reached its target date, and 38% thought their fund had a guarantee.

Target funds were designed to be the only investment you’d need for retirement. But people rarely use them that way. Only 19% of investors put as much as 80% to 100% of their assets in a target-date fund, according to a survey by AllianceBernstein.

And there’s another sticking point: A fund’s glide path doesn’t necessarily stop when you expect it to stop. Instead of ending in, say, 2010 or 2030, all of the major target-date funds continue to increase their bond allocations decades after the target date. “If it’s a 2030 fund, the glide path should end in 2030,” says Michael Case Smith, target-date portfolio manager at investment firm Avatar Associates. Fees also remain a concern. Some sponsors charge a management fee on top of expenses levied by the underlying funds in the target-date portfolios.

The right balance

Nearly 50 fund sponsors offer target-date funds, but three dominate the business. Funds from Fidelity, T. Rowe Price and Vanguard account for 80% of the $229 billion invested in target-date funds as of September 2009, according to Financial Research Corp. These three sponsors generally provide diversified portfolios with low fees. But there are significant differences among the trio:

T. Rowe Price: Most aggressive. Managers at T. Rowe Price are unabashed about investing heavily in stocks to guard against the risk that investors will run out of money in retirement. The company’s target-date funds hold as many as 17 other Price funds — including Kiplinger 25 members T. Rowe Price Mid-Cap Growth and T. Rowe Price Emerging Markets Stock. Funds that are furthest from their targets start out with 90% of their assets in stocks. They continue to hold about 60% in stocks when they hit their mark.

By comparison, Fidelity and Vanguard funds have 50% of their assets in stocks at their target date. Even 30 years after the target date, the Price funds still have a 20% stake in stocks. Meanwhile, Vanguard reduces its stock holdings to 30% after eight years; Fidelity’s timetable is 15 years.

Those numbers actually understate the aggressiveness of some target-date funds. T. Rowe Price’s 2010 fund holds 16% of its assets in high-yield, or junk, bonds, which are similar to stocks in terms of risk (Fidelity’s 2010 fund has a 20% stake in junk).

T. Rowe Price has no plans to change its strategy. Even though its 2010 fund fell 39% in the bear market, the fund had recovered most of that ground as of November 6. “We are staying the course,” says Jerome Clark, manager of T. Rowe Price’s retirement funds. “Having a higher stock allocation, even in retirement, defends against inflation and the risk that you’ll outlive your money.”

Vanguard: Lowest fees. We agree that stocks will perform well over a long period of time, and that’s why T. Rowe Price’s target-date funds are among our favorites. But what if you don’t want more than 70% of your assets in risky investments when you’re ready to retire? In that case, Vanguard funds are a solid choice.

Vanguard Target Retirement funds use a portfolio of five index funds plus actively managed money-market and Treasury inflation-protected securities funds (but no junk bonds). “It was the funds’ broad diversification that enabled them to avoid the worst of the market losses,” says John Ameriks, head of investment counseling and research at Vanguard. The 2010 fund lost 33% in the bear market and returned 0.7% annualized over the past three years through November 6.

And expenses are rock-bottom. The funds charge an annual fee of 0.18% or 0.19%, the lowest in the category.

Fidelity: In the middle. Fidelity’s Freedom funds, which debuted in 1996, are the largest family of target-date funds as measured by assets. They invest in a portfolio of Fidelity funds (but not Kiplinger 25 members Contrafund and Low-Priced Stock). Stacked up against T. Rowe Price and Vanguard, the Freedom funds are in the middle — not quite as aggressive as T. Rowe Price nor as cheap as Vanguard, but still attractive. The Fidelity 2010 fund lost 37% in the bear market but gained 3% annualized over the past five years through November 6. Fidelity also offers Fidelity Advisor funds sold through advisers, but they’re more expensive than the Freedom funds and their track records aren’t as good.

Unlike T. Rowe Price and Vanguard, Fidelity has altered its approach to target-date funds as a result of the market meltdown. In its 2050 funds, it has reduced its investments in U.S. stocks and boosted its allocation to international stocks from 20% to 30% (compared with Vanguard’s 18% and T. Rowe Price’s 23%). It also added funds that invest in TIPS and commodities. Fidelity recently launched a series of target-date funds with an underlying portfolio of index funds. For now, those funds are available only in retirement plans.

Some target-fund sponsors are trying completely different strategies. Putnam, for example, uses an “absolute return” approach in its ten Retirement-Ready funds. That means that over three-year periods the funds will try to generate returns that average one, three, five or seven percentage points per year above the inflation rate. But those returns aren’t guaranteed. With annual expenses between 1.25% and 1.34% and short track records, it remains to be seen whether the Putnam funds can deliver.

Schwab, on the other hand, has ramped up the stock portion of its 2040 fund from 79% to 91%, while scaling back stocks in its 2010 fund from 52% to 43%. “We really needed to reduce stock exposure in the years approaching the target date because that’s when our clients are most vulnerable,” says Daniel Kern, portfolio manager of the Schwab Target funds. “They have the most money at risk, limited earning power remaining in their careers and the highest level of anxiety.”

What you can do

When the dust settles, expect to see more disclosure about how funds invest after they hit their target date. Also, more firms will experiment with guarantees. For instance, Prudential offers products that allow retirement-plan participants to invest in target-date funds with guaranteed minimums of lifetime income. Prudential’s guarantee comes with a 1% annual fee in addition to the 0.59% expense ratio the target-date funds charge. Other firms, such as AllianceBernstein, are developing similar products.

But even these aren’t perfect. “With guaranteed options, there are concerns over cost and portability,” says Eric Endress, an analyst with CBIZ Financial Solutions who reviews target-date funds for plan sponsors. Guarantees cost more. Plus, most investors move their assets out of employer plans once they retire, so they end up paying for income guarantees they don’t use. Investors would also lose the guarantee if they rolled their accounts over to another firm.

In the meantime, you can ease your mind about your target-date fund by peeking under the hood. Morningstar now rates 20 families of target-date funds, and its Instant X-Ray tool gives you a clear view of your holdings and how much you have in stocks and bonds. In addition, the major fund sponsors provide details about their glide paths and asset allocations on their Web sites. And at www.djindexes.com, you can compare target funds’ performance against that of the Dow Jones Target Date indexes for free.

It’s also possible to cut the risk of your target-date fund by moving 10% of your retirement contributions into a high-quality bond fund or a stable-value fund, if your company retirement plan offers one (see Stable Funds in Chaotic Times). That’s not a bad move if you are within ten years of retirement and want less volatility. But you have to strike a balance between the risk of losing your principal and the risk of running out of money before your retirement ends.

Bottom line: All the fuss over target-date funds will mean little to most investors. As the markets recover, the debate sounds a lot like Monday-morning quarterbacking. Know what’s in your target fund and view it in the context of your overall assets. If you want to make drastic alterations to your fund, best to find another target fund that suits you. Or roll up your sleeves and build a portfolio of no-load funds from scratch.

From Kiplinger’s Personal Finance magazine, January 2010

Some exchange-traded funds have stopped issuing shares as regulators consider limits on commodities investing.

Call it collateral damage. Efforts by regulators to curb speculation in the futures markets have created unintended consequences for investors in commodity-oriented exchange-traded funds and notes. Few of these products actually hold physical stuff. It would be impractical for managers to store barrels of crude oil or bushels of corn. Instead, most ETFs and ETNs use derivatives, usually futures contracts, to simulate the returns of a commodity or commodity index.

The use of futures has made large ETFs and ETNs targets for regulators. The mess started on August 19, when the Commodity Futures Trading Commission revoked exemptions from limits on the futures positions of two ETFs: PowerShares DB Agriculture (symbol DBA) and Powershares DB Commodity Index Tracking (DBC). The commission expressed concern that the funds’ positions in the futures markets for grains had grown too large.

The commission’s action caused a stir among other commodity funds and notes. Fearing tighter limits on more futures positions, some sponsors stopped issuing shares. By doing so, their ETFs became similar to old-fashioned closed-end funds, which issue a fixed number of shares, then trade on exchanges.

One attribute of closed-end funds is that their share prices can trade above or below the value of a fund’s underlying assets, or net asset value per share. Because some ETFs stopped issuing new shares even as demand for commodity investments remained strong, the prices of a few ETFs have risen above their NAVs. For example, at its September 8 closing price of $10.28, shares of United States Natural Gas (UNG), one of the ETFs that had suspended issuance of new shares, traded at a 19% premium to its NAV.

Four other exchange-traded products stopped creating new shares: United States Oil (USO) and iShares S&P GSCI Commodity-Indexed Trust (GSG), both ETFs; and PowerShares DB Crude Oil Double Long (DXO) and iPath Dow Jones-UBS Natural Gas Subindex Total Returns (GAZ), both ETNs. Unlike an ETF, which buys the underlying futures contracts, an exchange-traded note is essentially a bond that promises to pay a return identical to the futures plus interest on cash collateral for the contracts.

The sponsor of one exchange-traded note that suspended shares is throwing in the towel. Deutsche Bank has announced that it will redeem all outstanding shares of its PowerShares oil ETN, which seeks to return twice the change in a crude-oil index on a daily basis. On September 9, Deutsche Bank will give investors cash equal to the NAV of each share they hold. Investors who purchased shares at a price above the ETN’s NAV will see that premium erode, although it’s still possible for them to make money if the price of oil rises during the time they hold the note. The ETN recently had $426 million in assets.

The CFTC is expected to decide position limits for exchange-traded products by the end of September. “We don’t have specifics of what those limits will be,” says John Hyland, chief investment officer of United States Commodity Funds, which sponsors the oil and natural-gas ETFs. “We assume that large commodities ETFs will have to own fewer commodity futures contracts than they own today.”

Meantime, don’t buy an ETF or ETN that sells for a big premium over the value of its assets. You can find information on premiums and discounts at Morningstar and ETFConnect.

Steep premiums on the funds and notes that have already suspended or may suspend issuance of new shares are likely to dissipate when the commission makes its decision. And some of those sponsors might follow in Deutsche Bank’s footsteps and liquidate their products. It’s best to wait until the smoke clears so you can get a better look at the commodity-based ETFs and ETNs left standing.

From Kiplinger.com

College students supply many of the offbeat picks for a unique fund.

The first thing you notice in Peter Ricchiuti’s office is the stuffed alligator head, its mouth wide open. Ricchiuti, a finance professor at Tulane University, in New Orleans, bagged the gator while hunting in the bayou. A former stock analyst, he now trains his students to track more elusive prey: small companies with untapped growth potential. More specifically, students hunt for these companies — “stocks under rocks,” Ricchiuti calls them — in the nooks of the Deep South.

Ricchiuti’s program is a training ground for investment analysts and money managers. Each year, he picks 46 companies and assigns his students, both undergrads and MBA candidates working in groups of three or four, to research them thoroughly. Their output, called Burkenroad Reports, is available free at www.burkenroad.org.

Fund angle

The research was good enough to persuade a small Mississippi bank to launch a mutual fund that makes liberal use of the students’ picks. Over the past three years to July 1, Hancock Horizon Burkenroad delivered a respectable annualized return of 14%, precisely the same as the average gain of all funds that focus on small, undervalued companies. Burkenroad research is “a great starting point” for the $11-million fund’s picks, says manager David Lundgren Jr. Recently, the fund held 57 stocks, 27 of them covered by Burkenroad analysts.

The student analysts work in a glass-walled, high-tech headquarters worthy of any big research operation. Inside, a wall-to-wall ticker relays stock prices for the companies Burkenroad analysts follow. There are Bloomberg terminals and large-screen TVs tuned to CNBC.

But the Burkenroadies aren’t shut-ins. They’re encouraged to rack up face time with executives of the companies they follow. “We get to walk in and meet with the CEO of the company, talk to the CFO and get a tour,” says Rob Tatum, 25, a recent MBA grad. And despite the youthfulness of the analysts, company officials take them seriously. The students “don’t take shortcuts,” says Al Petrie, of Energy Partners Ltd., an exploration company headquartered in New Orleans.

Dixie picks

Burkenroad students follow companies that are obscure, to put it mildly. Few pros cover the stocks, and they typically have a market value below $500 million. All are based in Alabama, Arkansas, Florida, Georgia, Louisiana, Mississippi or Texas.

One of Burkenroad’s biggest coups was a call on Hibbett Sporting Goods. In 2002, the students were among the first analysts to follow the Birmingham, Ala., retailer. Burkenroad rated the stock a buy and its shares have since soared from $11, adjusted for splits, to $36 in mid July. But the students didn’t get the story entirely right. Their most recent report, from November 2004, suggested that the stock was fully valued. At the time, the shares traded for just less than $25. Intrigued by Hancock Horizon Burkenroad (symbol HYBUX; 800-738-2625)? Its D shares levy no sales charge but carry above-average annual fees of 1.65%. Depending on your perspective, the fund is either a gimmick or a promising vehicle for cashing in on undiscovered stocks. And if you pick your own stocks, visit the Burkenroad Web site for ideas.

From Kiplinger’s Personal Finance magazine, September 2005

The rapid rise and fall of this gimmicky fund illustrates all the traits of a classic bad investment.

From Kiplinger.com:

Funds that stink are rarely worth a mention. But when a fund fails on every level — lousy strategy, unproven management, high expenses, a spotty track record, poor board oversight and a cheesy name — it certainly merits attention.

Click here for the entire article.

Kudos to the guys at the top who put their own money beside that of shareholders.

From Kiplinger’s Personal Finance:

Jeff Arricale and David Giroux wanted to show clients they were committed. The duo plowed all their retirement savings into T. Rowe Price Capital Appreciation after they took over the fund’s reins last July. “As our shareholders’ fortunes rise and fall, ours will as well,” Arricale says.

Click here for the entire article.