The downside of guarantees hits target-date funds

The dramatic decline of the markets has sparked a cascading wave of what are called “protection events” on products that offer principal or maturity guarantees. One of the asset categories most dramatically affected by this is the relatively new and popular group of target-date or lifecycle funds.

A popular type of lifecycle fund is one that offers a maturity guarantee attached to a “high-water mark” of the fund’s net asset value. If the investor purchases a lifecycle fund and holds it to maturity, the net asset value he or she receives will be the best performance of the fund over the prescribed period of time. For some funds, that could simply be its best closing daily net asset value.

When markets were high, there was no problem — clients could just keep locking in the gains. The market downturn, which has been far more pronounced than even some of the most pessimistic market commentators would have expected, means sponsors of guaranteed lifecycle products are stuck with maturity obligations that in many cases are more than 20% above the current value of the portfolio.

Sponsors will be hard-pressed to make up that kind of shortfall, so the losses have triggered so-called “protection events,” which force the portfolio’s assets to be allocated — sometimes entirely — to fixed income securities.

For funds that have a target date of less than five years, there’s little criticism about moving these funds into protection mode to preserve capital. Some fund sponsors have put products with a time horizon in excess of 10 years 100% into bonds and fixed income.

For instance, on Friday, Mackenzie Financial announced that its Destination+2020 will close to new purchases on December 31, 2008, and will be transited to the Destination+ Protected Portfolio. A company press release states, “The Protected Portfolio consists entirely of fixed income investments, including provincial and corporate bonds and cash equivalents.”

These products have already locked in a high-water mark NAV that investors are guaranteed if they sign on, meaning an investor is essentially buying a guaranteed discount to the maturity price. Given that the fund is made entirely of bonds and fixed income, it is almost impossible for it to exceed that NAV going forward.

Independent industry analyst Dan Hallett, president of Dan Hallett and Associates, says the problem is that the funds — which were initially geared toward providing an ideal asset mix for a client’s time horizon — have now shifted their focus to limiting the liability of the sponsor.

“This is one of my criticisms of these kinds of funds — there is intuitive appeal for a fund that is structured on a particular time frame, but once you throw the guarantee in there, in a situation like this, it automatically switches from an asset mix that is geared to the client’s time frame to the sponsor’s risk exposure,” he says. “It’s not covering the client at all. It’s covering the risk that the sponsor is exposed to. It’s understandable, but it’s one of the flaws of the product that they are trying to provide that guarantee.”

Hallett says it’s going to be difficult for these funds to make up guaranteed gains, given plummeting interest rates — which is why the industry is seeing so many protection events triggered in the guaranteed investment space.

“We’ve certainly seen it with a lot of the principal protected notes, which are not an identical structure, but the basic idea is the same,” he says. “If the market value of the underlying investment program goes below a certain threshold in relation to the amount of time that’s related to maturity, they have to revert to a bond to make sure they can make the promised amount. If interest rates are lower, then you need more money today to guarantee more to generate the x-amount of dollars due at maturity.”

Investors may still be tempted by the discounts, some of which are substantial. IA Clarington, one of the pioneers of the guaranteed target-date products, currently has its Target Click 2020 series valued at a 20.62% discount to the guaranteed NAV, and its Target Click 2025 series is short by almost 29.17%.

The question advisors have to ask is whether the guaranteed total return is worth the years of fees?

In the case of the Target Click funds, there is the ability to get back equity returns, notes Eric Frape, IA Clarington’s senior vice president of product and business development. The Target Click Funds have not suffered a protection event because they do not use the constant proportion portfolio insurance (CPPI) method to determine asset allocation.

Instead, IA Clarington uses an older method of guaranteeing principal by investing the necessary amount of money in a strip bond. It then disperses the rest of the portfolio’s allocation to cash and equity future contracts on market indices. The futures contracts ramps up the funds equity exposure at a ratio of 3:1.

Frape notes the CPPI structure does tend to perform better in stable market conditions, because it doesn’t have to allocate so much of the portfolio to the guarantee portion.

“Where the CPPI structure does not work as well if you have a volatile market like the one we’re in,” he says. “The market volatility forces the fund to take assets out of the equities and put them in fixed income component.”

For CPPI-based target date funds, there is virtually no chance that sponsors are going to increase equity exposure of the protected funds — it’s a possibility for longer time horizons, but the shorter target-date allocations are all but locked in.

BMO, which designated protection status for its BMO LifeStage Plus 2015 Fund in early October, said it will not change the asset mix again. It will, however, be lowering the management fee by up to 105 basis points.

“We are unable to rebalance back to a more aggressive mix. These funds are lifecycle funds that move from equity to fixed income (more conservative over time), and we do not make market timing calls by adding back to our equity component,” says Mark Stewart, senior manager of product development and management at BMO Mutual Funds.

Historical data returns would suggest even for a 2020 target fund, an investor could probably beat out a 20% total return. Investors who do opt to take the guaranteed discount are betting we’ll be in a market of diminished returns for at least another decade.

Hallett says even the non-guaranteed target date products are more heavily weighted to fixed income than they probably need to be.

“If someone wants to take advantage of market potential, they should get direct exposure to it,” he says. “What happens with even the longer dated lifecycle funds is that they get more conservative over time. The market plunge has taken care of bringing down market weighting. I think its better not to venture into one of these types of structures if you really want to take advantage of these low prices and the return potential of being in the market for a long period of time. Even within five to seven years, these funds start to get quite bond heavy.”

The burgeoning fund category is certainly not suffering, though. In fact, it was one of the few categories with positive sales in last month’s mutual fund sales, according to the Investment Funds Institute of Canada. The guaranteed maturities are proving popular in a market of extreme uncertainty.

Hallett also notes that many of the funds are sold on a deferred sales charge schedule, and the guarantees are available only at maturity. The oldest products are still only about four years old. All of this means investors have little incentive to redeem these funds.

“You’re not going to see redemptions yet because they are a relatively new product class,” he says.