Target-date funds are ideal for an investor who has a certain time frame in mind for her investments, often an anticipated retirement date. They are designed to be a single investment vehicle from the entry of an individual into the workforce until retirement. Another use for target-date funds includes saving for college. However, there are risks associated with target-date funds. They can vary widely in their performances across funds with the same target date. Although they are designed to simplify the investment process for less-sophisticated investors, they are still subject to the overall volatility of the market. Investors should understand how target-date funds operate and whether they are appropriate for their portfolios.
Structure of Target-Date Funds
Target-date funds are a type of mutual fund that automatically rebalances the holdings in the portfolio based on the target date. Target-date funds most often contain a mix of stock, bonds and cash in their portfolios. The asset allocations are geared toward more-aggressive investments in stocks farther away from the target date. As the investor moves closer toward the target date, the fund allocation generally shifts toward less-risky allocations in bonds and cash.
Benefits of Target-Date Funds
The main advantage of target-date funds is their simplicity. They can provide a single investment vehicle for retirement savings. The assets in the funds automatically rebalance based on the fund’s target date. The investor does not need to worry about asset allocation. The funds are professionally managed and allow less-sophisticated investors to access a higher degree of expertise.
Risks of Target-Date Funds
Even though target-date funds are meant to be a single financial planning product for retirement, they still entail risk like all investments. A target-date fund is subject to the risk of the underlying assets. For a target-date fund that holds other mutual funds, there is the risk associated with the individual mutual funds.
Target-date funds may have the appearance of low volatility, but this is not the case. Many investors were surprised by the loss of value of target-date funds during the 2008 financial crisis. A target-date fund is not immune from a substantial drawdown if the overall market goes down. Further, the bond investments in target-date funds still have the same risks of interest rate risk, credit risk and inflation risk, as with all bonds.
Considerations for Target-Date Funds
Investors should consider a number of factors before investing in a target-date fund. One of the most important issues is the cost for the fund. Some funds may charge higher expense ratios than individual mutual funds. The industry average expense ratio for target-date funds is around 0.66%. While this is not an unreasonable amount, it can reduce returns on the investment over time. Some investors may be better off in widely diversified mutual funds with lower expense ratios.
Another consideration is the capabilities of the investment management firm. The investment firm is responsible for the selection of individual securities for the fund and the changes in allocation over the fund’s lifetime. This is a different task than merely picking stocks or bonds for a simple diversified mutual fund. The investment firm must utilize investment managers who are capable of making these decisions. Further, the investor must also be assured the investment firm will not change its strategy over the lifetime of the fund. A divergence in strategy could have a major impact on returns and volatility.
Investors should consider the fund’s equity glide path. The equity glide path is a term describing the change from stocks to bonds over the fund’s expected lifetime. Target dates have different returns over their lifetimes. The structure of the equity glide paths is one of the main reasons for the differing returns. Even funds with similar target dates may have varying returns due to different equity glide paths. Further, funds may change their equity glide paths over time, as well as the type of assets these funds hold. Investors need to be aware of these changes.