For those investing for retirement, target-date funds sound like a great idea. Say you want to retire in 2030. Simply purchase a 2030 target-date fund, the wisdom holds, and the fund will do a lot of the heavy lifting for you when it comes to your investments.
But like that time you tried to pass your literature midterm by scanning the CliffsNotes of Crime and Punishment , taking the easy way out may not be your best strategy here either. As one expert says, target-date funds are "the one-stop shop for mutual fund investing." In selecting the holdings comprising the fund, target-date fund managers choose a higher concentration of high-risk, high-return holdings in early stages, gradually converting to lower-risk holdings as the target date nears.
The result is that the target-date mutual fund investor is investing more aggressively at younger ages, when he or she can afford to take greater risks, and more conservatively at later stages, when lower risk is the order of the day and something to be avoided.
"A target-date fund is really a mutual fund of mutual funds, because instead of owning a basket of stocks or bonds, they own a basket of other mutual funds," says Phillip R. Christenson, chartered financial analyst with Phillip James Financial in Plymouth, Minn. "Each fund has a 'glide path' that dictates how the fund will adjust its allocation over time."
For example, he says, a 2030 target-date fund might start with a 75% allocation to stocks. By the time 2030 arrives, the fund's allocation will have been adjusted down to perhaps 35% in stocks, reducing the risk.
The result is that one of the most challenging aspects of investing for retirement, asset allocation, is performed for the investor. The investor gains diversification across a variety of asset classes, and enjoys the sense of not having to wade even toe deep into the varying merits of different investment choices. That makes target-date funds a favored choice among many who recognize the need to invest for retirement but are new to the market and relatively unschooled in its nuances.
Not so fast
Unfortunately, like a lot of areas of life that promise an easy approach if you put on blinders to cost and just leave things to others, target-date mutual funds have a number of drawbacks. The first, and one of the biggest, is that they tend to suffer from above-average expense ratios.
And those higher expenses can nibble away at returns over a longer period of time, like between now and, say, the year 2030.
Another negative is that in an ideal world, a number of factors making up your individual investor profile would be taken into account in determining the right investments for you. They would include your financial goals, your investment time horizon, your income, your assets outside the stock market and your ability to sleep at night should the market cliff-dive. But target-date funds consider only one of those factors, investment time horizon, in their investment allocations.
An additional downside is that target-date funds operate as if you have no other assets in your portfolio. Again, in a perfect universe, when making investment choices you would choose stock market investments you don't already hold. Doing so adds the attractive virtue of greater diversification to your portfolio.
But when choosing target-date funds, you may be investing again in stocks you already own, resulting in less, not more diversification.
In addition, says Christenson, "a [target-date] fund won't know if you have other stocks in your portfolio, so the fund may have you at a 50% allocation to stocks, but when you look at your overall portfolio, that's actually allocated 70% to stocks. Is that the right allocation for you?"
Under the hood
One of the most suspect issues about target-date funds is this: If you are retiring in 2030, you'll want to know the target-date mutual fund is selecting underlying investments just right for that 16-year window.
But how can you be sure it will achieve that goal when different 2030 target-date funds have widely differing investments underpinning them? You'll be taking on more risk in some 2030 funds, less in others, based on which you choose.
Christenson examined a number of target-date funds for the same year, finding that not only did the allocation differ, from say 80 to 70% in stocks, but the quality of the investments varied as well. "One fund might invest in very high-grade bonds, whereas another might invest in riskier junk bonds," he says.
"You have to look under the hood to see exactly what they own."
Hmm. And how many target-date mutual fund investors will even know how to open the hood?
Ultimately, what many tout as target-date funds' greatest attribute, simplification , ends up as their undoing as a bull's-eye of a great investment. These funds not only simplify, they oversimplify. That turns out to be a significant handicap in a world where every investor is different, and requires different investment strategies.
The ultimate takeaway on target-date funds: aim higher.
This article originally appeared on FiveCentNickel .
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