Index Funds vs. Target-Date Funds: An Overview

Choosing between index funds and target-date funds in a 401(k) is a common dilemma. The main factors in making this choice are how much investors know about financial markets and how much time they want to spend. Target-date funds provide easy-to-understand options that work reasonably well for most investors. With target-date funds, all investors need to know is when they want to retire. Index funds let people directly invest in different asset classes, which usually saves on fees and gives them more control over risk and returns.

Index funds mirror the performance of a stock or bond index, often at a low cost. Expense ratios are usually at or below 0.1% for U.S. stock and bond index funds, and they can be less than 0.2% for international assets. However, investors are left on their own. They must put these assets together in ways that minimize risks for a given level of expected returns. That's great, as long as you're interested in modern portfolio theory (MPT).

Target-date funds can use both managed and index funds to create portfolios that professional managers believe are appropriate for investors. As the target date approaches, managers reduce the allocation to risky assets, such as international stocks, and increase the portion of funds dedicated to less volatile assets like bonds. Most of the best target-date funds have expense ratios of less than 1%, and some even go below 0.1%. As a rule, target-date funds that invest in index funds tend to charge less.

Key Takeaways

  • Index funds offer more choices and lower costs, while a target-date fund is an easy way to invest for retirement without worrying about asset allocations.
  • Index funds include passively-managed exchange-traded funds (ETFs) and mutual funds that track specific indexes.
  • Investors can combine index funds themselves to get performance similar to target-date funds and reduce fees in the process.
  • Target-date funds are actively managed and periodically restructured to gradually reduce risk as the target retirement date approaches.
  • Target-date funds can be riskier than most people expect, but they usually become less volatile than individual stock market index funds as the target date approaches.

Index Funds

Index funds are popular with both individual investors and financial professionals. They include exchange-traded funds (ETFs) and mutual funds that are created to track a specific index like the S&P 500, the Russell 2000, or the EAFE. Index funds offer broad exposure to the market and have low operating expenses.

Index funds span the gamut of stock and bond investment styles, both domestically and internationally. Others may track obscure indexes or exotic asset classes, such as Brazilian small-cap stocks. However, those types of index funds rarely appear in 401(k) plans.

An S&P 500 index fund, an international stock index fund, and a bond index fund provide enough variety to serve as the core of a diversified portfolio. Other helpful additions to the mix include small-cap stocks, mid-cap stocks, emerging market stocks, and perhaps real estate investment trusts (REITs). With access to these asset classes, investors can quickly build diversified portfolios for themselves using index funds and save money.

Like any other investment, there are risks involved in index funds. Moreover, any setback that affects the benchmark will be seen in the index fund. If you're looking for flexibility, you won't find it with an index fund, especially when it comes to reacting to price drops in the index's securities. You'll have to change the asset allocation yourself by investing in different index funds.

While most index funds are low cost, some come with a high price. For example, the Rydex S&P 500 Fund (RYSOX) has an expense ratio of 1.68%. That is astounding when you consider the fact that funds with identical holdings often charge less than 0.05%. High-cost index funds are a particular issue in 401(k) plans that contain mostly managed funds, so be sure to check the fees.

Target-Date Funds

Target-date funds are worth considering if your company offers them. You can either invest all of a 401(k) account in the appropriate target-date fund or invest in a selection of the investments from the plan's full lineup.

The reason they're called target-date funds is that the assets are restructured at a future date to serve the investor's needs. Mutual fund companies frequently name the funds after the target years. The idea is that the investors will need the money that year, often for retirement purposes. Rather than having to choose a series of investments, an investor can choose one target-date fund to reach their retirement goals.

Target-date funds are in many 401(k) plans. However, company plans usually only offer access to target-date retirement funds from a single provider. Fidelity, Vanguard and T. Rowe Price are popular choices. All three use their own funds as the underlying investments. Other firms may offer different strategies, such as funds of exchange-traded funds (ETFs).

What seems like an appropriate level of risk to a fund manager might not fit your life. Look at target-date fund performance in 2008 and early 2020 to see if a given fund seems too risky.

Some investors are under the false impression that target-date funds always have lower risk than S&P 500 index funds. That is not necessarily true. These funds sometimes start by investing heavily in risky assets like emerging markets and small-cap stocks in an attempt to boost long-term returns. Fund managers reallocate holdings at regular intervals and reduce risk as the fund gets closer to its target date.

Target-date funds suffered significant losses again in 2020 after a similar episode in 2008. For example, the T. Rowe Price Target 2025 Fund (TRRVX) lost over 20% at one point during the 2020 market crash. That loss might seem excessive to some investors who are only five years away from retirement. Transferring a portion of assets to a government bond ETF is an easy way to reduce overall risk (and expected returns).

Special Considerations

Actively managed mutual funds such as target-date funds have gotten a bad rap. In many cases, it is well deserved. However, not all actively managed funds are poor investment choices. For example, Vanguard's Wellington Fund combines reasonable fees with almost a century of strong performance. Many other managed funds also offer consistent returns, proven investing strategies, and sensible expense ratios. The real competition isn't between index funds and target-date funds. Instead, investors must choose to put their savings into a single target-date fund or several individual funds, which may be index funds or managed funds.

It is best to have an asset allocation in mind for those going this route. If the 401(k) plan is the only investment, then this account is the only one to consider. Many have other investment accounts, such as individual retirement accounts (IRAs), a spouse’s workplace retirement plan, or taxable investments. In that case, a 401(k) plan allocation is just one part of an overall portfolio.