Target-date funds are designed to provide a simpler investment solution for portfolios with a set investment horizon, for example, a college savings plan or an individual retirement account (IRA). These funds start aggressive, and as the target date approaches, the fund mix becomes more conservative.
Target-date funds are named by the year in which the investor is presumed to begin making withdrawals. For example, Vanguard Target Retirement 2020 Fund is expected to have an asset allocation strategy designed for investors planning to retire in or around the year 2020.
Here’s a simplistic comparison of two Vanguard target-date funds with very distinct target dates. The Vanguard Institutional Target Retirement 2020 Fund had a 52% allocation to equity, 47% to fixed income and 1% to cash, and cash equivalents as of December 31, 2018. The Vanguard 2060 Fund on the other hand had 88% allocated to equity, only about 10% to fixed income, and about 2% to cash and cash equivalents as of 12/31/18.
Many IRA participants prefer the “set-and-forget” convenience of target-date funds. The low expense ratios of these funds are also an attractive feature. Another advantage of a target-date fund is that you don’t have to individually rebalance the allocations. The fund automatically does that for you periodically. Some of the largest and popular managers of target-date funds in the United States include Vanguard, Fidelity, Goldman Sachs, T. Rowe Price, Blackrock, and Northern Trust.
Asset mix as target date nears
In general, the target-date fund becomes more conservative over time. What that generally implies is that the percentage of bonds will increase in comparison to stocks. However, it is important to note that while stocks are perceived to be riskier than bonds, some stocks are less risky than other stocks and some bonds hold higher risk than other bonds. In addition, the risk changes with market conditions. For example, in a rising interest rate environment, bonds lose value because bond prices are inversely proportional to interest rates.
Hence it is critical to evaluate what the target-date fund invests in over time. The fund prospectus will detail the fund strategy. Different funds with the same target date but different managers will have different strategies and different asset mixes. You don’t necessarily have to invest in a target-date fund with a target date that matches your retirement date. You should be able to adjust your allocations to different target funds periodically. One may want to want to invest in funds that better match your risk-return profile.
Another very important consideration is the expense ratio or fees the fund charges. Those fees are deducted from your net assets in the fund. These fees can differ significantly among different fund managers. The fund charging the highest in fees has to perform significantly better than that charging the lowest to yield the same return to the investor. The fees will reduce your assets and hence should be a critical criterion in evaluating your options.
The fees are also a function of the underlying assets in the target-date fund. If the fund invests in a bunch of actively managed mutual funds or ETFs that charge more fees than a passive or an indexed fund, the fund will charge the investor a higher fee to recoup these costs. In conclusion, the above factors for selecting a target-date fund need to be evaluated holistically.
Having said that, there are many advantages to investing in target-date funds.
Advantages of target-date funds
- These are the simplest investments you will encounter.
- You can easily automate the investment process with a set and forget approach.
- They offer professionally managed portfolios at a relatively low price.
- The asset mix changes automatically over time and they get less risky as the target date nears.
- They offer both indexed funds and active funds in the mix.
- Fewer options means fewer things to worry about.
- Perfect for retirement accounts, college savings accounts, IRA, HSA, etc.
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