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.
- 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 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 traditionally-diversified portfolio. Those looking for riskier or less common investment options can choose index funds specializing in small-cap stocks, mid-cap stocks, emerging market stocks, or real estate investment trusts (REITs).
Upside to Index Funds
Index funds are intended to help investors achieve slight portfolio diversification. While an investor is still at-risk if their entire portfolio encompasses the S&P 500, an index fund is a way for an investor to easily gain access to dozens of companies without having to individually invest in each security.
Using this strategy, an index fund investor likely only pays a single portfolio management fee. Alternatively, the investor would have to individually buy each security, incurring dozens of transaction fees. In addition, the investor would have to monitor and rebalance their portfolio to reflect the appropriate composition of the underlying market.
Downside to Index Funds
Like any other investment, there are risks involved in index funds. 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 inexpensive, some come at a high price. For example, the Rydex S&P 500 Fund (RYSOX) has an expense ratio of 1.65%. In addition, index fund offerings may be limited within 401(k) plans. Though broad markets offer thousands of options, your company's retirement plan is likely heavily restricted with much fewer choices.
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).
Today, target-date funds are only offered as mutual funds. There are no equivalent ETFs listed at the moment. Index products come in both mutual fund and ETF options.
Upside to Target-Date Funds
If you're interested in a "set it and forget it" style of investing, target-date funds are more appropriate for you. The fund will automatically rebalance and shed risk as you appropriate retirement.
Target-date funds also have the advantage of typically being more diversified than broad index funds. Target-date funds are comprised of equity and fixed-income investments; as an investor gets closer to retirement, the fund will sell equities and buy bonds. As opposed to an index fund that might only invest in one industry or type of security, a target-date fund is often spread across multiple securities.
Downside to Target-Date Funds
Target-date funds are not as ideal for investors who want more control over their portfolios. If you have a specific asset allocation in mind, a target-date fund will not work for you as the asset allocation automatically changes over time.
Target-date funds are often more expensive than index funds. Target-date funds are more often managed and require more action on the behalf of the broker offering the investment vehicle. In addition, target-date funds may give off the impression of security but are often as risky - if not more so - than index funds. For example, target-date funds suffered significant losses again in 2020 after a similar episode in 2008. The T. Rowe Price Target 2025 Fund (TRRVX) lost over 20% at one point during the 2020 market crash.
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.
hat 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).
Index vs. Target-Date Funds: Which Is Better?
Often less expensive
Less diversification per single fund
Does not rebalance asset allocation over time
Often more choices within a 401(k) plan
More diverse offerings (different types of assets or sectors)
Often more expensive
More diversification per single fund
Rebalances asset allocation over time
Often many but not as many choices within a 401(k) plan
Less diverse offerings (not many different types of assets or sectors)
How Do I Pick an Index Fund?
Each index fund will come with a ton of information about the security holdings of the index, the weight of each security, management fees, historical performance, and strategy of the fund. Begin by contemplating your investment strategy. Then, use a broker's website to search and filter index options that meet your investment criteria.
Which Target-Date Fund Should I Choose?
A target-date fund is often set up based on an individual's retirement date or age. If you wish to follow industry-wide guidance on your asset allocation, pick the target-date fund whose year corresponds to when you are planning to retire.
Should I Invest In an Index Fund or Target-Date Fund?
Both funds are great options - the difference comes down to how much control you want over your investments. With both choices, you're already sacrificing some control as you do not have a say in the underlying securities and weights.
With that said, index funds are often better for investors wanting more control over their portfolio. Target-date funds will automatically rebalance and change your asset allocation.
What Are the Downsides of Target-Date Funds?
Target date funds tend to be somewhat more expensive than traditional mutual funds or ETFs, largely because they are structured as funds-of-funds and are more actively-managed than passive index funds. But, fees on target-date funds have been trending lower. Another downside is that target-date funds are typically offered in 5-year intervals (e.g., 2030, 2035, 2040, and so on), which means if you plan to retire, in say 2042, you may not have exactly the optimal allocations, although such differences may be small. Another word of caution is that if you use a target-date fund, it should be almost your entire allocation, and you should not mix and match different target-date funds. These defeat the purpose of the target-date fund's inclusive set-it-and-forget-it approach.
The Bottom Line
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.
Regardless of the investment option you choose, it is best to have an asset allocation in mind. If you prefer to actively manage this allocation, index funds are likely the better choice. If not, sit back and let your target-date funds carry you into retirement.