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Open vs. Closed Target-Date Funds: Is There a Difference?

Target-date funds (TDFs), simply, are mutual funds that invest “to” a certain date and rebalance over time to meet the needs of the investor at that time. For example, a young investor invested in a TDF might find the fund to be more aggressive, with a higher ratio of equities. As that person nears retirement the fund will adjust to a more conservative asset allocation to preserve capital and meet their retirement needs.

Within TDFs it is important to understand that there are two investment architectures: open and closed. An open architecture will include both in-house or proprietary funds of the manager as well mutual funds managed by other firms. A closed architecture is a fund in which there are limited mutual funds within the TDF and most are operated by a single firm providing the product.

The Pros and Cons

There has been much written and discussed about the two architectures. Which is better for investors? What performs better over time? In reality, there are pros and cons to each form. For example, those in favor of an open architecture argue that managers are free to select from the best performing funds regardless of where they originated. Also, managers are not chained to any one management style and can diversify. Those that manage closed funds, on the other hand, often say that in-house management reduces fees and allows for more control over investments by using in-house management and risk/reward structures as opposed to relying on an outside manager where you are at the mercy of their management styles.

There are also arguments against each fund architecture. Opponents of open funds say they can be expensive and difficult to research. There is also the chance for “over-diversification” which can be confusing to novice investors. On the other hand, critics of closed architecture say the style can cause conflicts of interests if too much money is being invested in-house simply to raise company profit, and there is the possibility of too little diversification if only one manager is being used.

In July 2014, Morningstar released its Target-Date Series Research Paper. In it they said, “Open architecture series should have the ability to draw from the industry’s best, but these series have shown no performance advantage over closed-architecture series.” Interestingly, however, it is fees that come into play when looking at returns, with the implication that closed funds are more attractive to the cost-conscious investor. The report continues: “Open-architecture series pay systematically higher fees to access non-proprietary managers, and those costs eat into returns.”

Some of the biggest TDF providers in the U.S. are Fidelity Investments, Vanguard, and T. Rowe Price. The Fidelity Freedom K 2020, 2030, 2040 and 2050 funds have an average compound return of 9.3% for the five years ending March 31, 2015. Vanguard’s Target Retirement 2020, 2030, 2040 and 2050 funds have a compound return of 10.4% over the same time period. Both are closed-architecture funds.

The Bottom Line

Given the Morningstar assertions of “no performance advantage,” investors are hard pressed to decide which route to take when looking at TDFs. If cost is not a factor, perhaps performance is, but if the high fees of outside management eat into performance and profit, investors may want to consider a closed-architecture fund that keeps a lid on fees and management expenses.
Image courtesy of renjith krishnan at FreeDigitalPhotos.net
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Sep 25, 2015