Target Date Funds

I keep seeing target date mutual funds pop up in my daily readings. Presumably that means they are a popular item  at the moment.

I can understand why target date funds might be popular with investors. However, they are not investments I would normally recommend to clients.

Here is why. 

Target Date Mutual Funds

What is a target date fund? According to Investopedia:

A target-date fund adjusts the assets in the fund to line up with your retirement timeline. If you’re planning to retire in 15 years, you might pick a target-date fund of 2025 or 2030. The fund manager will adjust the holdings and when you near retirement age, that fund will hold a lot of bonds, instead of the more risky stocks.

You might also see these funds as life-cycle funds. I think my comments from a couple of years ago are still applicable (although I seem to have been a little more diplomatic back then).

The concept is based on sound investing theory. Investors with a long time horizon (i.e. young adults) can afford to take on relatively high investment risk in the pursuit of greater expected returns. As investors approach retirement age, they should shift their portfolio constantly over time to lower risk assets. Someone one year from retirement likely does not want to be invested in a portfolio that may fall 20% in the final year.

A target date approach is a strategy that you will use in your investing. Outsourcing it to a professional may make sense.

Target Funds Are Not My Cup of Tea

Simple, something one should do anyway, and professionally managed. So why do I not like target date funds?

The linked article covers my concerns nicely.

You Are Unique

You are unique as an investor. And definitely more than simply your number of years until retirement.

You will have short, medium, and long-term investment objectives. Retirement is obviously a key objective, but there are others. What about the home you may wish to buy in 5 years? Or the plan to quit your job and return to school?

Same with personal constraints. Perhaps an illness impacts the family, altering cash flows in and out. Or maybe you get married or have a child. These events impact one’s life and investing strategies.

Accumulated wealth to date also factors in to one’s investing strategy. If you are 45 with no capital saved you will may have to take on more investment risk than another 45 year old with $2 million in the bank.

So does your personal risk tolerance level.

Focus on your comprehensive Investor Profile. One that incorporates all these variables into your overall strategy.

Do not simply use a planned retirement date to determine an appropriate asset allocation over the various stages in your life cycle.

Incremental Cost

You will incur higher management fees to have someone else shift the fund’s asset allocation over time. And costs are a significant drag on investment success.

As for the expense ratios cited in the Investopedia article, the 0.71% average for stock funds is misleading. That ratio accounts for a wide variety of funds, including actively managed and niche funds. Taking a passive management approach by investing in index mutual or exchange traded funds should result in significantly lower actual fees for investors.

Paying someone to reallocate your portfolio over time is not what I consider to be a beneficial expenditure. Especially in light of the fact that, as we saw above, a one size fits all approach is probably not best for your unique situation.

Buy and Forget Is Never Prudent

Fund companies must love target date funds.

A 30 year old invests in a fund with a target date equal to age 65. The fund company has his money basically locked away with them for the next 35 years. Not bad. For the fund company.

Given the structure, I would guess that investors maintain their investments in a target date fund longer than a non-target date fund.

While I like buy and hold, I do not like buy and forget. Regardless of the structure, investors need to periodically monitor their investments and assess performance against pre-determined benchmarks.

Comparing a target date fund – with its shifting asset allocation and composition – may require a little effort from the investor. But it needs to be done to ensure that you are investing in a superior asset.

The Bottom Line

While individuals should want to gradually reduce their portfolio risk as they move through their life cycle, I am not sure target funds are the best vehicle. Investors are more complex than simply a retirement date. And the additional fees associated with target funds are, in my opinion, probably poor value.

Instead, create a well-diversified investment portfolio that reflects your individual circumstances using low cost index funds. Periodically review your portfolio and adjust your asset allocation as your situation changes.   It is not that much effort and the money you save and reinvest will pay off in the long-run.

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