In today’s narrative of "set it and forget it" investing, investors are often told to trust the market. This is akin to leaving a newborn unattended or driving a car without checking the gas. But we all know that anything worthwhile requires attention and effort. Investing demands our active participation and vigilance, not passive neglect. Investing is not a spectator sport. It demands our active participation, our keen eye, and our unwavering vigilance. To suggest otherwise is to invite financial disaster.
Target date funds have surged in popularity in recent decades as a "set it and forget it" investment option, particularly within 401(k) retirement plans. These funds automatically adjust their asset allocation mix of stocks, bonds, and cash equivalents to become more conservative as the target date (usually retirement) approaches. For many investors, the appeal is simplicity and automation - you choose a fund with a date close to your anticipated retirement year and the fund handles the rest.
However, while target date funds can be a convenient "hands-off" solution, they are not a panacea. As with any investment, it's critical to look under the hood and understand what you own. A deeper examination reveals several potential advantages but also significant drawbacks that any prudent investor, especially those with sizable assets, must carefully weigh. Let's explore the good, the bad, and the ugly of target date funds.
The bottom line is that while target date funds can play a useful role for some investors, especially within 401(k)s, they are far from a silver bullet. For investors with significant assets in particular, their one-size-fits-all approach and lack of customization are major limitations that must be carefully considered. Wealthy investors are usually better served by a tailored portfolio that holistically considers their full range of investments, risk tolerance, income needs, and other goals - not just their age. As with any investment, it's critical to look beyond the marketing hype and understand exactly what you own, so you can make an informed decision about whether target date funds are right for your unique situation.
The Good:
Automatic rebalancing and de-risking: The primary selling point of target date funds is that they automatically adjust their equity/fixed income mix to become more conservative over time. This occurs through a "glide path" where the stock allocation gradually decreases and the bond allocation increases as the target date nears. Younger investors further from retirement will have a more aggressive allocation to capture growth, while those closer to retirement will have more in bonds to preserve capital. This automatic rebalancing and de-risking can help investors avoid the common behavioral pitfall of failing to adjust their allocation as their time horizon and risk tolerance changes.
Broad diversification Most target date funds provide broad diversification across multiple asset classes, countries, sectors, and securities within their stock and bond holdings. Diversification is a key tool for managing risk. By bundling together many investments that don't all move in lockstep with each other, these funds aim to provide a smoother ride and more consistent returns than a concentrated bet on a single security or asset class. The instant diversification can be especially useful for beginner investors or those with smaller sums to invest.
Low minimum investments Many target date funds have low or no minimum investment requirements. This provides an accessible way for investors to obtain broad diversification without a large sum of capital. By contrast, building a comparably diversified portfolio of individual stocks and bonds could require significant money and effort.
Professionally managed Target date funds are constructed and managed by investment professionals. In theory, this provides investors with access to professional asset allocation, security selection, and risk management that they may lack the time, inclination, or expertise to implement on their own. Of course, the quality of the management varies by fund.
Simplicity and convenience For investors who lack the desire to actively manage their own portfolio, target date funds can simplify investment decision-making down to a single choice - selecting a fund with a date closest to your anticipated retirement year. This can encourage some people to start investing who might otherwise be deterred by the array of options.
Popularity in 401(k) plans Target date funds have become a staple of 401(k) plans. They are often the default investment option when participants are automatically enrolled. According to Morningstar, target-date strategies held $1.9 trillion in assets at the end of 2020, accounting for about 40% of total 401(k) plan assets. For investors who want to keep their retirement planning simple by holding the same investments across their 401(k) and other accounts, target date funds can facilitate that.
Potential for lower costs than other funds While target date fund fees vary, some of the largest offerings from major providers like Vanguard and Fidelity have been able to keep costs quite low due to economies of scale. Since target date funds are usually structured as "funds of funds" holding other mutual funds, their overall costs depend on the expenses of the underlying holdings. Index-based target date funds can be especially cost-effective. That said, investors must still compare costs carefully, as not all target date funds are cheap.
The Bad
One-size-fits-all approach The convenience of target date funds comes with a major drawback: they are a blunt instrument based on one data point (expected retirement date). They don't consider an investor's risk tolerance, other assets, income needs, tax situation, or other goals. Two people planning to retire in the same year may have vastly different circumstances, but a target date fund will treat them identically. Wealthier investors in particular are more likely to have unique factors that call for a more tailored approach than target date funds provide.
Lack of customization Expanding on the previous point, target date funds offer little to no customization. The asset allocation and glide path are set by the fund company for each retirement date, with zero flexibility to adjust for individual situations. An investor who wants to be more aggressive or conservative than the baseline allocation is usually out of luck (although a minority of 401(k) plans are starting to offer limited customization options for an extra fee). By contrast, investors building their own portfolios can tailor their allocation as they see fit.
No control over underlying investments Target date fund investors also don't have any control over the specific securities the fund invests in. The fund manager selects the underlying investments, usually a mix of other mutual funds from the same company. Investors cannot add, remove, or adjust the weightings of individual holdings based on their own investment views. Those who want to express tactical tilts or avoid certain exposures are hamstrung.
Potential for high costs Not all target date funds are bargains. Many still charge hefty fees on top of the costs of the underlying funds they hold. According to Morningstar, the asset-weighted average expense ratio for target-date funds was 0.52% in 2020. For an investor with a $1 million portfolio, that equates to $5,200 per year. And some funds charge significantly more than the average. Higher fees eat away at returns over the long term.
Inconsistent asset allocations and glide paths across funds There are no industry-standard asset allocation ranges or glide paths for target date funds. Two funds with the same target date from different providers could have meaningfully different equity/bond/cash mixes, and follow different trajectories for adjusting that mix over time. Some are more aggressive, holding higher stock allocations for longer, while others become quite conservative early on. This makes it difficult for investors to compare funds and select the most appropriate one unless they dig into the portfolio details.
Overexposure to the fund company's own investments Most target date funds are composed of other funds run by the same fund company (e.g. Fidelity target date funds own only Fidelity stock and bond funds). This raises concerns of the fund company sacrificing diversification and "best-in-class" investment options to direct assets to their own offerings. It can result in a target date fund having outsize exposure to a certain investment style or being underexposed to asset classes the company doesn't offer, rather than a truly optimal mix.
Lack of downside protection and customized risk management Finally, while target date funds reduce risk over time at a high level by dialing down stocks and dialing up bonds and cash, they don't provide active downside protection or risk management tailored to an investor's specific needs. The funds will fall in line with broader stock and bond markets, and usually don't tactically adjust allocations based on market conditions. Investors still need to be prepared to weather full market volatility, especially with funds far from their target date. Those who want more dynamic risk management must look elsewhere.
The Ugly
Misuse of target date funds Perhaps the ugliest aspect of target date funds is that many investors use them incorrectly as an all-in-one solution without understanding the nuances. According to a survey by the Employee Benefit Research Institute, nearly two-thirds of 401(k) participants believe target date funds provide guaranteed income in retirement, which they do not. Many investors also don't grasp that funds with the same target date can have significantly different allocations and risk profiles. This confusion leads to investors taking on more (or less) risk than they intend.
Over-reliance on past performance Another common misuse is investors chasing target date funds with the highest historical returns, without looking under the hood. But past performance is not indicative of future results, and can lead investors astray if the outperformance came from taking more risk. The SEC has even warned that some target date funds are marketed based on past returns in a way that obscures their future risk of losses.
Failure to adjust for other investments Target date funds are intended to be an investor's full retirement portfolio. But many investors use them in conjunction with other holdings, which throws off the overall allocation. For example, an investor might have a target date fund in their 401(k) but hold other stock funds in an IRA, resulting in a total equity allocation much higher than intended. This "overlap" can inadvertently concentrate risks.
Lack of inflation protection Target date funds' shift to bonds and cash over time exposes them to inflation risk. Inflation erodes the purchasing power of fixed income assets. This is especially concerning given the funds' retirement focus, as retirees can be particularly vulnerable to inflation. While some target date funds have started incorporating inflation-protected securities and other real assets, their overall inflation protection is still limited. Investors must look elsewhere for true inflation hedges like commodities and real estate.
Vulnerable to interest rate changes The increased fixed income exposure of target date funds as the target nears also makes them more vulnerable to interest rate changes. When rates rise, bond prices fall. This is an acute risk in the current environment, where interest rates are historically low and poised to rise. Target date funds could face significant headwinds from rate increases in the coming years.
Potential for style drift Target date funds are designed to be long-term investments, but their holdings can still experience "style drift" over time as the managers of the underlying funds change. For example, a large-cap value fund owned by the target date fund could gradually become more growth-oriented under new management. This can make the overall portfolio riskier or more volatile than intended. Investors counting on the target date fund to deliver a certain exposure may be in for a surprise.
Misleading labels and conflicts of interest Finally, there are concerns about target date funds being inaccurately labeled and marketed in ways that obscure risks. The SEC has warned that some funds understate their vulnerability to losses. There are also potential conflicts of interest, as many 401(k) plan sponsors are also compensated for administrative services by the same companies offering the target date funds. This could incentivize them to favor certain funds over others, regardless of suitability for participants.
The information contained in this Higgins Capital communication is provided for information purposes and is not a solicitation or offer to buy or sell any securities or related financial instruments in any jurisdiction. Past performance does not guarantee future results.
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