3 Misconceptions About Passive TDFs: Schwab

Not all passive TDFs are structured the same, with notable variances in key areas such as asset allocation, index selection and glide path that can all affect portfolio performance both in the short and long term.

"There can be value in looking at different designs, looking at structures that will incorporate active and passive," Gilliam explains.

For example, the report looks at how three passive TDFs in the marketplace offer very different glide paths based on the number of asset classes, the allocation mix between these assets, the exposure to alternative or traditional assets, and the size of risk-asset allocations at retirement.

Each of the passive TDFs uses a different mix of asset classes, both in terms of the number of different categories included in the portfolio, as well as the sub-asset classes used in each segment. These types of active design decisions can translate directly into risk and return variances for investors, according to the report.

With this in mind, the report notes that a specific passive TDF can be an appropriate choice for a particular plan's participants, but the evaluation process to reach this decision should include numerous inputs, of which cost is only one.

"The key message here is that it has to be the right fit for the plan … and the exposure that the participant's getting needs to have been thoroughly vetted beyond just the cost component," Gilliam told ThinkAdvisor.

Misconception No. 3: Active or passive is an either-or choice.

According to the report, implementation can be fully passive, fully active, or a blend of both — with pros and cons for all three approaches.

"All things being equal, lower fees will translate into higher returns. However, all things are not equal across TDFs, given the flexibility providers have in portfolio design," the report states.

The report also points to the growing segment of blended active and passive TDFs, which can help bridge the best of both of these worlds.

The report looks at the pros and cons of each approach. Passive implementation can provide a plan with an effective, low-cost QDIA, but this approach might affect performance and force certain glide path decisions.

Meanwhile, an active implementation typically strives to add portfolio value for a higher fee. And these TDFs generally seek to adapt portfolios through time for return-seeking opportunities or for risk management by investing in underlying securities at different weights than the benchmark. This approach also creates risk that the underlying strategy managers may make the wrong investment choices and underperform.

A blended implementation combines both passive and active approaches by investing in both low-cost index funds as well as active managers to gain select market exposures. Using both types of strategies can allow the TDF manager to refine active risk levels at different parts of the glide path and may also provide diversification as markets cycle. A blended approach has a generally modest fee increase over a pure passive implementation approach.

—Related on ThinkAdvisor:

• 4 TDF Investing Myths: SSGA