Target Funds: Good in Theory, Bad During Market Volatility

Article by Investment U

It seemed like such a good idea 10 years ago when discussing allocation options for 401(k) and 529 college savings plans. Rather than doing your own research and rebalancing in your portfolio, you can just invest in a fund that does it for you depending on your time horizon.

Back then, target-date mutual funds were a niche product, and now in the present, they’re a fixture in the retirement-savings industry.

These instruments are relatively still new – they were created in 1993.

The funds invest in a mix of stocks, bonds and other investments that gets more conservative as an investor’s retirement, or target date, approaches, rebalancing automatically for investors who prefer not to or don’t know how to do it themselves. They’re available in more than 80% of larger 401(k) plans.

As part of the Pension Protection Act of 2006, target-date funds were made one of a few permissible “default options” for retirement plans with an automatic enrollment feature, meaning some employees are automatically enrolled in the funds.

Investments in the funds have ballooned more than 380% since 2005 to about $343 billion.

The Two Major Concerns

This does seem like a good idea, but besides performance, there are two major concerns in the make-up of these vehicles.

1. The fund is only as good as the fund company managing these investments. Because these are funds that are invested in other funds, a company typically will use funds within their own line-up. If the fund company isn’t up to par in certain investment areas, you may be out of luck and take some losses. The overall quality of the company is very important to the quality of the fund you’re investing in.
2. Are the expenses worth it? For the cost-conscious investor, the expenses built into target-date funds can be out of hand. Since they are “funds of funds,” they spread assets among multiple other investment vehicles. As a result, target-date fund expenses span an unusually wide range. The differences can add up. According to human resources consultant Towers Watson, an increase of just $50 per $10,000 in target-date fund fees could cost a high earner the equivalent of eight years’ worth of retirement savings over the length of his career.

The Last Four Years…

The average fund with about four years until its target date fell 0.4% last year, according to Morningstar, Inc. That lags behind the S&P 500 Index, which gained 2%, including dividends, and is well below the Barclays Capital Aggregate Bond Index, which rose nearly 8% for the year.

Many target funds also had a lackluster performance during the market crash of 2008. Afterwards, they seemed to be doing well until 2011.

Analyst state that target funds’ wide variety of investment holdings was detrimental to their returns in 2011, as many investors fled to blue chips and Treasuries. “They’re intended to be diversified, and that should be an advantage over the long term,” says Josh Charlson, a fund analyst with Morningstar. “But it’s not always going to work so well, particularly when there’s a flight to quality in the market.”

And take note. Presently, the average fund approaching its target date is allocated in about 40% equities. This is only down three percentage points from 2008 when there were similar struggles, according to Lipper.

Time horizons and This New Normal

Depending upon your target date, you probably want to take control of your portfolio because these funds have shown they do worse than their peers during economic adversity. As far as expenses are concerned, an index fund could serve that purpose without fees taking some of your return.

Also take into account that the last few years have shown this new normal where what we think should happen really doesn’t come about (i.e. printing money and inflation or Treasuries with a 0.2% return).

Good Investing,

Jason Jenkins

Article by Investment U