Morningstar Analyst Ratings: Closing the Investor Return Gap Kathryn Spica, CFA Senior Analyst, Fund-of-Funds Strategies October 11, 2014 2014 Morningstar, Inc. All rights reserved. The Morningstar name and logo are registered marks of Morningstar. Marks used in conjunction with Morningstar products or services are the property of Morningstar or its subsidiaries.
Investor Shortfall Asset-weighted investor shortfall for all open-end funds: 2.49% Domestic Equity 1.66 International 3.01 Taxable Bond 2.24 Municipal Bond 1.88 Balanced 2.12 Alternative 2.11 Sector Equity 3.14 2
Moving Beyond Past Performance Achievement Test 3
Moving Beyond Past Performance Aptitude Test 4
The Ratings Spectrum 5
The Five Pillars People Process Parent Performance Price 6
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The Five Pillars People A comprehensive evaluation of managers' talent, tenure, and resources. 8
People Pillar 9
Hatteras Alpha Hedged Strategies / Analyst Rating: Neutral / People Pillar: Neutral 10
Hatteras Alpha Hedged Strategies / Analyst Rating: Neutral / People Pillar: Neutral 11
TFS Market Neutral / Analyst Rating: Gold / People Pillar: Positive 12
TFS Market Neutral / Analyst Rating: Gold / People Pillar: Positive 13
TFS Market Neutral / Analyst Rating: Gold / People Pillar: Positive 14
The Five Pillars Process What is the strategy, and how does it translate into the portfolio? 15
Process Pillar 16
Fidelity Large Cap Stock / Analyst Rating: Silver / Process Pillar: Positive 17
Dreyfus Appreciation / Analyst Rating: Silver / Process Pillar: Positive 18
Fidelity Large Cap Stock / Analyst Rating: Silver / Process Pillar: Positive 19
Dreyfus Appreciation / Analyst Rating: Silver / Process Pillar: Positive 20
Fidelity Large Cap Stock / Analyst Rating: Silver / Process Pillar: Positive 21
Fidelity Large Cap Stock / Analyst Rating: Silver / Process Pillar: Positive 22
Fidelity Large Cap Stock / Analyst Rating: Silver / Process Pillar: Positive 23
Dreyfus Appreciation / Analyst Rating: Silver / Process Pillar: Positive 24
Dreyfus Appreciation / Analyst Rating: Silver / Process Pillar: Positive 25
Dreyfus Appreciation / Analyst Rating: Silver / Process Pillar: Positive 26
Process Pillar 27
Vanguard Total Bond Market Index / Analyst Rating: Silver / Process Pillar: Positive 28
Vanguard Total Bond Market Index / Analyst Rating: Silver / Process Pillar: Positive 29
Dodge & Cox Income / Analyst Rating: Gold / Process Pillar: Positive 30
Dodge & Cox Income / Analyst Rating: Gold / Process Pillar: Positive 31
Process Pillar 32
Vanguard Total Bond Market Index / Analyst Rating: Silver / Process Pillar: Positive 33
Vanguard Total Bond Market Index / Analyst Rating: Silver / Process Pillar: Positive 34
Vanguard Total Bond Market Index / Analyst Rating: Silver / Process Pillar: Positive 35
Dodge & Cox Income / Analyst Rating: Gold / Process Pillar: Positive 36
Dodge & Cox Income / Analyst Rating: Gold / Process Pillar: Positive 37
Dodge & Cox Income / Analyst Rating: Gold / Process Pillar: Positive 38
The Five Pillars Parent What priorities prevail at the firm? Stewardship or salesmanship? 39
Parent Pillar 40
American Funds / Parent Pillar: Positive 41
AllianceBernstein / Parent Pillar: Negative 42
The Five Pillars Performance Why did the fund behave a certain way in different markets? 43
Performance Pillar 44
Oppenheimer Global / Analyst Rating: Silver / Performance Pillar: Positive 45
Oppenheimer Global / Analyst Rating: Silver / Performance Pillar: Positive 46
Oppenheimer Global / Analyst Rating: Silver / Performance Pillar: Positive 47
Oppenheimer Global Opps / Analyst Rating: Bronze / Performance Pillar: Positive 48
Oppenheimer Global Opps / Analyst Rating: Bronze / Performance Pillar: Positive 49
Oppenheimer Global Opps / Analyst Rating: Bronze / Performance Pillar: Positive 50
Oppenheimer Global / Analyst Rating: Silver / Performance Pillar: Positive 51
Oppenheimer Global / Analyst Rating: Silver / Performance Pillar: Positive 52
Oppenheimer Global Opps / Analyst Rating: Bronze / Performance Pillar: Positive 53
Oppenheimer Global Opps / Analyst Rating: Bronze / Performance Pillar: Positive 54
The Five Pillars Price Is the fund a good value proposition compared with similar funds sold through similar channels? 55
Price Pillar 56
LKCM Equity / Analyst Rating: Silver / Price Pillar: Positive 57
LKCM Equity / Analyst Rating: Silver / Price Pillar: Positive 58
LKCM Equity / Analyst Rating: Silver / Price Pillar: Positive 59
BlackRock US Opps / Analyst Rating: Neutral / Price Pillar: Negative 60
BlackRock US Opps / Analyst Rating: Neutral / Price Pillar: Negative 61
BlackRock US Opps / Analyst Rating: Neutral / Price Pillar: Negative 62
FAQs 63
Distribution of Fund Analyst Ratings 450 400 350 300 250 200 150 100 50 0 153 297 362 407 40 US Open-End & Closed-End Universe; Data as of 6/30/2014. 64
Morningstar Analyst Rating Medalists 10.1% US Open-End & Closed-End Universe: 8,109 Distinct Portfolios. Data as of 6/30/2014. 65
Measuring the Success of the Analyst Rating 120 % Trailing 10-Year Average 100 80 68.81 80.34 92.19 79.76 95.42 60 40 20 0 U.S. Equity International Equity Balanced Taxable Bond Municipal Bond Data as of 6/30/14 66
Highlights from Morningstar s Fund-of-Funds Research and Ratings 67
Target-Date Research and Ratings First launched target-date series ratings and reports in Fall 2009 Analyst coverage of 24 of the largest open-end target-date series Five-page, in-depth reports, updated quarterly Annual industry survey 68
Key Distinctions of Target-Date Series Ratings Target-date ratings consider an overall series a holistic view of a set of funds across a glide path Quantitative elements: Several purely quantitative elements to rating, including Performance, Price, and Portfolio People: Analysis of target-date series considers both asset-allocation managers and underlying fund managers Key commonality: Overall rating is forward-looking and analyst-driven 69
Big Three Maintain Their Hold 2013 Market Share of Target-Date Firms Fidelity, Vanguard, and T. Rowe make up 73% of target-date mutual fund assets, down from almost 80% in 2008 On average, inflows to target-date funds account for one third of fund company s net new flows in 2013 70
Typical Target-Date Fund: Portfolio Structure Active funds still predominate Fully passive series still in minority, but growing (newer offerings from Fidelity, TIAA-CREF, BlackRock, John Hancock) Index-based funds make up 33% of industry, up from 10% in 2005 Fund-of-fund structure is predominant; quality is solid. 71
Typical Target-Date Fund: Open and Closed Architecture Closed-architecture strategies remain in majority (Fidelity, Vanguard, T. Rowe Price, American) But legacy open-architecture series hold ground while newer series have gained traction (Great-West, Guidestone, Hartford) Updated Morningstar analysis in 2014 showed little performance difference between open-architecture and closed Fees eat into open architecture series returns: 0.92% average expense ratio for open, versus 0.81% for closed 72
Typical Target-Date Fund: Price Fees continue to trend downward, but wide disparities persist. Use of index funds, elimination of overlay fees, lower-cost underlying shares, and fee waivers contribute to lower fees. Fidelity Freedom Index series beat Vanguard as lowest cost target-date series in 2014 73
Where Are the Innovations? Innovations have been coming in several areas: Adding diversified asset classes/alternatives Risk/volatility management Tactical allocation Glide path reconsiderations Many of these innovations have been driven by reactions to the losses incurred in 2008 and/or the need to differentiate new products in a crowded marketplace. 74
Increasing Diversification Most notable trend in this area has been addition of commodities and real asset strategies to glide paths. Differing approaches: indexed vs. active approaches, straight commodities vs. diversified real-asset sleeves Firms that have added these asset classes include T. Rowe Price, Principal, Fidelity, Voya, Russell. Long/short and absolute-return funds less common, but many firms exploring Modest use of long/short or absolute-return strategies by JPMorgan, DWS, MFS, John Hancock, American Century. Putnam made its Absolute Return funds a major part of its target-date series in 2010. 75
Increasing Diversification (cont.) Many firms have been increasing strategic allocations to foreign equities over the past few years. Fidelity, T. Rowe Price, and Vanguard all raised foreign-stock allocations from 20% to 30% of equity assets. Some firms, such as AllianceBernstein, have raised foreign stocks to as high as 40% weightings. Some providers, in more modest fashion, have increased allocations to emerging markets. 76
Tactical Allocation While standard approach in target-date industry has been to rely on the strategic asset allocation, some firms have incorporated elements of tactical allocation Tracking error bands tend to be limited, in 1%-2% range Difficult for investors to assess success of such strategies, although have seen small edge recently. 13 of the strategies under coverage use tactical management. Fidelity has recently added this capability to its actively managed series. 77
On the Horizon Other buzz-generating issues for target-date providers: Retirement income challenges: Diversifying fixed-income portfolios. Guaranteed income: Concerns of portability, cost, insurer solvency. A few options, but little uptake. Collective investment trusts Provide ability to invest in direct real estate Lower costs, less transparency Custom target-date solutions that can be modified for individual preferences and circumstances 78
529 College-Savings Plans Research and Ratings 64 plans receive ratings and research, representing nearly 98% of industry assets Data on 4,600 529 investment options Morningstar Categories Morningstar Ratings Annual industry survey 79
College-Savings Plans Continue to Gain Traction Assets have grown to $200 billion today from $200 million in 1998. Both advisor-sold and direct-sold plans have garnered more assets, with direct-sold plans keeping a slight market-share edge. 80
Morningstar Analyst Ratings for 529 Plans Analyze direct-sold plans separately from advisor-sold plans State benefits can offset weaknesses Plans from states with portable benefits or no local benefits compete nationally Pillars are not equally weighted (same for fund ratings) Team of 529 analysts review all ratings 81
Average Equity Stake Steady, Range Remains Wide Age-based options are a popular choice among college savers, and the typical glide path across the industry in 2013 is slightly more equity heavy in the middle years than that of prior years. 82
Direct-Sold Open-Architecture Plans Gain Edge Open-architecture plans outperformed closed-architecture plans among direct-sold options. 83
Concentration of Investment Options Sponsors are selecting strong stewards of capital to manage their plans investment options. 84
Performance Gap Remains Majority of static 529 categories trail traditional open-end peers. Age-based options also lag behind blended benchmarks. Direct-sold options show strong relative performance. 85
Costs Have Come Down but Create a Drag On both an absolute and relative basis, 529 categories are becoming less expensive. Still, 529 fees are higher than traditional open-end mutual funds. Dollar-based fees further add to costs. 86
Program Managers and States Provide Dual-Levels of Oversight Ascensus reigns as direct-sold program manager by assets. American Funds is the dominant player in advisor-sold. Program Manager Total Assets Ascensus $33,239,641,956 American Funds $44,225,300,021 87
Trends: More Plans Introduce Passive Options Maine s NextGen College Savings Plan Select introduced an ishares agebased track in November 2013 Schwab 529 College Savings Plan of Kansas launched indexed age-based and static options in July 2013 In September 2013, Rhode Island approved the creation of age-based tracks in CollegeBoundfund and CollegeBoundfund Direct in 2014 88
Trends: Plans Continue to Cut Fees Fidelity cut the program management fee on indexed options in its plans to 9 basis points, from 15 basis points ScholarShare College Savings Plan of California eliminated a 5 basis-point administration fee on passive portfolios in November 2013 Pennsylvania 529 Investment Plan reduces expenses by 11 basis points for each investment option (but introduces an $18 account maintenance fee for paper statement delivery) Utah Educational Savings Plan trims its administrative asset fee, dropping costs by as much as 4 basis points for age-based and five static options The Vanguard 529 College Savings Plan drops age-based and balanced options expense ratios to 0.19% each 89
Trends: Dollar-Value of Tax Benefits Varies Widely Among States Dollar Value of State Tax Benefits, Based on $1,200 in Annual Contributions Issuing State Tax Parity State Income Tax Rate, Couples Earning $50,000 CollegeChoice 529 Direct Savings Plan IN 3.40% Credit, 20% Vermont Higher Education Investment Plan VT 3.55% Credit, 10% State Tax Dollar Value Deduction of Tax Limit, Filing Savings on Jointly $1,200 in Annual 529 Contributions $240 $120 Oregon College Savings Plan OR 9.00% $4,455 $108 MOST Missouri s 529 Plan MO Yes 6.00% $16,000 $72 CollegeAdvantage 529 Savings Plan OH 4.11% $2,000 $49 Fidelity Arizona College Savings Plan AZ Yes 2.88% $4,000 $35 90
Morningstar Analyst Ratings, 2013 Morningstar Analyst Ratings for 529 College-Savings Plans -- Gold State Sales Channel Maryland College Investment Plan MD Direct T. Rowe Price College Savings Plan AK Direct The Vanguard 529 College Savings Plan NV Direct Utah Educational Savings Plan UT Direct 91
Morningstar Analyst Ratings, 2013 Morningstar Analyst Ratings for 529 College-Savings Plans -- Silver State Sales Channel CollegeAdvantage 529 Savings Plan OH Direct CollegeAmerica VA Advisor ishares 529 Plan AR Advisor Michigan Education Savings Program MI Direct ScholarShare College Savings Plan CA Direct 92
When the investor wins, we all win. 93
Q&A Kathryn Spica, CFA kathryn.spica@morningstar.com 312-384-3991 94