Target-risk funds: Pricier than the sum of their parts

Adding a second layer of fees is the norm.

Jeffrey Bunce, CFA 22 June, 2016 | 5:00PM

Editor's note: In today's second installment of this week's three-part series on target-risk funds, manager research analyst Jeffrey Bunce discusses the impact of fees on investor returns. The series, which is based on a research paper released this month by Morningstar Canada's manager-research team, began on Monday and will conclude on Friday.

Simply put: Fees matter. Both Morningstar's findings and academic research indicate that fund expenses are one of the better predictors of future performance. The higher the fee, the harder it will be for a fund to outperform or achieve a return as high as a similar fund with a lower fee.

Most target-risk programs layer additional fees on top of those charged by the underlying funds they hold, resulting in a higher cost hurdle to clear.

In our study of 30 target-risk funds with a similar asset mix (approximately 60% equity and 40% fixed income), each from different programs, the stated management-expense ratios (MERs) in the commission-based channel were compared with an estimate of the weighted average MERs of their underlying holdings.

Of the 30 funds, just five charged fees equal to the cost of the underlying holdings and only two charged less. Half of the funds in the sample charged a substantial premium -- more than 20 basis points -- and another eight added a smaller premium. Overall, the average MER for the funds in our sample was 2.25%, which was 32 basis points higher than the average cost would be if the target-risk funds were priced on the basis of the underlying funds they held.

Not surprisingly, the lowest-cost funds in our sample -- BMO Balanced ETF Portfolio and TD Managed Index Balanced Growth Portfolio -- invest passively. While they are a relative bargain next to their competitors in the sample, the gap between their MERs and those of their holdings is among the largest in the sample. BMO's fund is 1.45% more expensive and TD's fund is 0.78% higher. This is partly due to the fact that these portfolios' underlying funds incorporate either lower trailer fees than the portfolio itself (in the case of the TD funds), or no trailer fees at all (in the case of the BMO ETFs).

Given their static asset allocations and relatively simple portfolios, these funds arguably are the easiest to replicate on one's own. They provide the benefit of rebalancing, but otherwise the value proposition is difficult to discern.

While the two passive offerings in our sample look relatively attractive on price even with a hefty layer of additional fees, the same isn't true for funds whose underlying holdings aren't particularly cheap to begin with. For instance, if the MER of TD FundSmart Managed Balanced Growth were to reflect only the cost of its underlying holdings, it would land in the middle of the pack, based on our 2.02% estimated price-tag. But because of an additional charge of 0.71%, the fund's actual MER, at 2.73%, ranks as the highest in our sample. (This remains true even after TD implemented a fee reduction to the FundSmart suite in 2015.)

With a fairly static asset allocation, the passive BMO and TD offerings have a weaker case for their price premium than rivals, like Invesco Intactive Balanced Growth Portfolio, which tactically manage their asset mixes. The Invesco portfolio fund could conceivably boost returns or reduce risk by adjusting its holdings to reflect market conditions.

The Invesco fund's managers face a considerable price hurdle to overcome, however. Consisting of a mix of active funds and ETFs, the underlying holdings add up to a 1.54% MER, versus 2.29% for the fund's stated MER -- a wide 0.75% gap. This disparity shrinks when we tag a 1% commission on to the ETF holdings to reflect the fund's commission-based distribution channel. Even after making that adjustment, the price gap between the MERs of the underlying holdings and the portfolio fund's MER would still be a substantial 0.35%.

It may well be that the benefits of savvy tactical asset allocation or even smartly constructed static portfolios are worth the costs. We expect our future research will shed light on this question, but the simple arithmetic of investment costs will always give lower-priced funds an inherent advantage.

About Author

Jeffrey Bunce, CFA

Jeffrey Bunce, CFA  Jeffrey Bunce, CFA, is a senior investment analyst for Morningstar’s Investment Management group.