Target Date Funds Miss Their Mark
Posted by Black Opulence on June 30, 2009
Let’s face it for the majority of people when it comes to investing and the stock market their knowledge is extremely limited. As such Wall Street has developed ways to make it seem as though investing is not that hard and that “anyone can do it.” They even developed phrases to make it seem simple.
Mutual funds have become the investment of choice for many as they build in diversification and professional management. A simplified version of an “all in one” investments would be a fairly safe way to describe it. But what happens when mutual funds start to become too complicated for the average investor? Wall Street looks for ways to make it even simpler…
Introducing the Target Date fund.
Target date funds (or lifecycle funds) are the new kid on the block (outside of ETFs) for investment simplification and are now found in virtually all employer plans (i.e. 401k plans). In the federal government’s thrift savings plan (TSP) they are known as the L funds. They are easy to recognize as they typically have dates associated with their nomenclature. For example, 2010 fund, 2030 fund, etc. The basis for the name is to coincide with the perceived retirement date of the investor in the fund. For example, a person with a 2010 funds is expected to be entering retirement around the year 2010.
The fund’s objective is geared towards keeping the investments more risky (heavily weighted towards stocks) early on in the investment period and as one gets closer to retirement the fund would become more conservative (less risky) in nature. Of course this is all accomplished within the fund so the investor does not need to do anything. It all happens automatically. Well if you have paid any attention to the headlines recently, this has not exactly been the case. During a recent hearing about target date funds SEC Chairman Mary Schapiro noted that “returns of 2010 funds last year varied from -3.6% to -41%.” Now how is that possible?
Well like most things not all target date funds are built alike or similar in investment philosophy. In other words, some funds have a greater allocation to stocks or bonds longer than others. So in a year like 2008 when the sock market went down by 38 or so percent, a target date fund with a 2010 date and a high exposure to stocks (possibly as high as 70%) would have had terrible performance last year. And so the red flags were raised with investors of these funds. Remember their retirement is only a year away…thus the scrutiny that has come to target date funds.
There are over 250+ target date funds and chances are you only have one in your employer plan. The choice is probably offered by the company that administers the plan but there are multiple versions of the same fund at different companies. You only have one of the available options. So hypothetically if you have a 2010 fund offered by Fidelity your exposure to stocks would be 42% whereas the same 2010 fund from AllianceBernstein has 67% allocated towards stocks. (I just checked their websites.) For people who are risk adverse the latter is probably be too risky for someone a year away from retirement. Especially when the fund is supposed to be reducing its exposure to stocks.
Enter the Glide Path…
Huh, what? Glide who? Yes glide path…chances are you have no idea what I am referring to but you should. Glide path refers to the pace at which the fund becomes more conservative over time. If the glide path is lengthy (or slow to take place) you might have an exposure to the stock market a lot longer than you expect.
Last but not least, many people are using the funds incorrectly and are unaware they are doing so. It all has to do with asset allocation (how much money you have allocated to the various sectors of your portfolio). Target date funds tend to be funds made up of other mutual funds from within the same fund family. Simply put, a fund of funds. So by their vary nature the proper way to use them is to use them exclusively without using any other funds. Many times investors are using the 2010 fund, 2020 fund and the 2030 fund thinking they are getting more diversification but that is not the case. By investing in other funds you cause the asset allocation of your portfolio to be out of whack and can make the portfolio a lot less efficient, more risky and sometimes more costly (greater fees).
As I stated earlier with Wall Street nothing is ever as simple as it seems and target date funds are yet another example of this. If you choose to use target date funds please take the time to do your due diligence on them or seek the counsel of a qualified financial professional. Remember there are no short cuts when it comes to Wall Street.
