Many people lack the time, the knowledge, or the inclination to identify, select and allocate the most appropriate investments for their long-term goals. For these people, mutual fund companies have created two types of asset allocation funds designed to provide all-in-one solutions that investors can, for the most part, set and forget. The first to be introduced was the risk-based fund, also referred to as an asset allocation fund, which was followed by the target-date fund. Both offer the do-it-yourself investor a simple solution to investing; however, they differ in several ways.
How They Work
Target-date funds have grown in popularity, and they are the fund of choice over risk-based plans for many employer-sponsored retirement plans. Target-date fund portfolios are allocated based on an investor's current age; they gradually adjust the allocation from more aggressive or moderate to conservative as the investor ages and the target date draws nearer. Target-date funds are established around specific retirement time frames that the investor can select. Over the life of the fund, the fund manager incrementally reduces the risk by changing the allocation from stock investments to bond investments following a predefined glide path. With some target-date funds, the glide path ends at the retirement date; for other funds, it continues through retirement. The difference affects how quickly the reallocation occurs.
Risk-based funds are not constructed around a glide path or a target retirement date. Instead, they target a general risk profile, which can range from very conservative to aggressive. The portfolios contain a mix of stock investments and bond investments that most closely reflect the risk profile; a higher allocation of stock investments matches a more aggressive risk profile. Unlike target-date funds, which dynamically change their allocations over time, risk-based funds are static, keeping the same allocation mix without regard to the age of the investor.
Both funds offer professional management, broad diversification, and portfolio rebalancing, but that is where their similarities end.
Advantages and Disadvantages of Target-Date Funds
The biggest advantage of a target-date fund is the fund manager does the work of managing the risk allocation so the investor does not have to worry about it. For that reason, it is truly a set-it-and-forget-it solution. The investor simply chooses a fund with a target date closest to his own retirement date and lets the fund do all of the work.
However, the glide path that the fund manager uses to adjust the fund’s allocations is generally based on the average investor. Your particular risk profile may evolve at a different rate than the glide path. At some point, the portfolio allocation may not match your risk profile; it could become too aggressive or too conservative for your tastes. In addition, each fund manager's perspective of an appropriate glide path and its rate of change can be different. For that reason, it can be difficult to compare target-date fund performance on an apples-to-apples basis.
Advantages and Disadvantages of Risk-Based Funds
With a risk-based fund, investors can more closely match a particular asset allocation model to their own risk profiles. Once selected, the allocation model never changes. If, based on your own assessment, your risk profile changes, you can simply shift your funds into a more appropriate fund or maintain a combination of funds for a more gradual change. Because the portfolio models are static, it is easier to compare similar allocations offered by different mutual fund companies.
Risk-based funds require a clear understanding of your risk profile. Because your risk profile is likely to evolve over time, you must constantly reassess your risk profile to ensure that it still matches the allocation model you have chosen. There are plenty of risk assessment tools available online. Mutual fund companies, such as Vanguard, offer risk assessment tools for free; along with the results of the assessment, they offer recommendations for appropriate allocation models.
The Bottom Line
If you want the peace of mind an all-in-one investment solution can bring, target-date funds and risk-based funds can be good choices. The target-date fund is definitely a more hands-off solution as long as you select the right target date. The risk-based fund can more accurately reflect your specific risk tolerance at any given time, but it does require some hands-on attention to make the proper changes at the right time for your needs. If you are going to invest in either a target-date fund or a risk-based fund, have a clear understanding of your particular needs, objectives and investment preferences as you research the funds.