Should you make a Date with a Target-Date Fund?

Thanks to the stock markets’ great recovery since 2009, individual investors have returned to buying stocks at a rate not seen since the third quarter of 2007. According to the Federal Reserve’s Z.1 Release in October 2014, households now have 35% of their assets—or $13.3 trillion—invested in the stock market.

But what may surprise you—in light of all the attention paid to individual stocks—is that $7.7 trillion (more than half) of those monies are dedicated to mutual funds. And when you delve into that number, it makes sense, as some 43% of all mutual funds assets can be attributed to the growth of retirement plans like the 401k, which often limit investors to funds or ETFs.

What’s more interesting to me is that Morningstar reports that 30% (more than double the 13.8% in 2004) of those investments are in passive mutual funds, or funds that attempt to replicate the holdings and returns of a specific market index. In other words, there is no manager individually picking the stocks for the fund; its holdings mirror the stocks represented in the index. And essentially, the goal is, if the index moves (in either direction) by 10%, so should the fund. Due to fees and such, the replication is never exact, but it generally comes close.

And since just 32% of active fund managers have actually beaten their target indexes—for the past five years—I guess we can see why passive funds have come back into favor. They are easy; just stick your money in them, sit back, and—especially if you have a long-term horizon—expect it to grow into a healthy nest egg for your retirement.

While many investors ride the tails of the broad indexes, like the S&P 500 and the Russell 2000, target-date funds have made a big comeback. With these instruments, you buy a fund with a target, or specified date, close to your planned retirement time. Then the investment asset mix changes as you grow older, to a more conservative approach.

Growing at Double-Digit Rates

This “buy-it-and-forget-it” investing strategy is gathering assets at a brisk rate. Morningstar’s 2014 Target-Date Series Research Paper notes that target-date funds grew to more than $600 billion in 2014, up 10.5% from 2012.

A lot of the growth can be attributed to the Pension Protection Act of 2006, which encourages employers to automatically enroll new employees in 401(k)s, and the default option is “target date” funds.

It sounds great, doesn’t it? But for a stock-picker like me, and an investor that has ridden up and down many cycles, I become somewhat nervous if it sounds too easy. I’m not saying a target-date fund should not have a place in your portfolio. They have garnered some good reviews. A 2014 report from Charles Schwab showed that target-date funds weren’t as volatile as the general market during the recession, and also that they did better than the S&P 500 Index from 2008-2012.

Some Cautions

But I would just caution you not to put all your retirement assets into one. Here’s why:

•  Your investing goals and risk tolerance are unique to you. While some investors can withstand a 30% overnight loss without batting an eyelash, others would be weeping in their cereal bowls. A one-size-fits-all strategy rarely works with anything. As well, many investors say they have a long-term outlook, but their actions negate that. Consequently, at the first sign of a decline in their funds’ return, they want to bail, potentially destroying their chances of benefiting from this retirement vehicle. Target-date funds are for the long-term investor, not made to be jumping in and out.

•  Young investors who buy a target-date fund will often see 80% to 100% of their monies invested in stocks. That could be good or bad, depending on the market. And if the market—and the fund—takes a big dive—say, 20% or 30%—young investors may run for the exits and become so disillusioned that they never come back to the market.•  Investors in passive funds often don’t pay much attention to the individual holdings. Therefore, a particular stock or sector experiencing an adverse event could heavily weigh down the overall returns. And you—the investor—don’t have any say in whether you keep or sell that stock or sector.

•  Morningstar’s report also stated that most target-date managers don’t put their money where their mouths are. In fact, only one—Hans Erickson of TIAA-CREF Lifecycle—has more than $1 million invested in a target-date fund he manages.

•  If your target-date fund holds a lot of bonds, rising interest rates could cause severe losses.

•  Because the more than 600 existing target-date funds vary as to fee structure, risk profile and asset mix, it’s tough to compare performance, and that’s usually a defining measure when deciding what fund to purchase. That’s especially true for the customized target-date plans that are now popping up in 401(k)s. As well, many of the funds don’t have a ticker symbol, so that makes comparisons even more difficult.

If you Decide to Take the Plunge…

Having said all that, it’s clear that target-date funds are enticing to individual investors. So if you do decide to invest in one, there are a couple of important considerations:

Check the Expense Ratio. The lower, the better, and under 0.50% is best. And while Morningstar reports that that the asset-weighted average expense ratio for target-date funds has declined from 1.04% in 2010, it was still 0.91 percent in 2012.

Understand the Guide Plan. Check the fund’s glide plan, or how the assets change as you grow older. “Through” plans tend to have more of a growth strategy, and may be better suited for investors that have other retirement assets, as they will tend to take on more risk to obtain that growth. For investors with more limited assets, a “to” plan, getting you up to retirement may be preferable, and will tend to be more conservative.

As with all investments, the more you know, the better off you will be. And no matter what investment you buy, I never recommend a “buy-it-and-forget-it” strategy. The most successful investors not only know “what” they buy, they keep a close watch on their holdings, to prevent costly surprises and to take advantage of new developments that may provide additional opportunities for profit.


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