Target date funds are all the rage these days.
According to Ibbotson Associates, as of the end of 2012, there is more than $485 billion invested in target date funds. That's a lot of money. Investors and advisers have their futures and reputations riding on them.
A big part of the growth of the target date fund business can be attributed to employer sponsored retirement plans like 401ks. Many plans set target date funds as the default investment option. Lots of investors opt for them anyway because of the ease of use.
Conceptually target date funds are fantastic. Pick a fund with a target date that matches your objective, dump some money in it and make periodic contributions - simple and effective.
The fund will automatically adjust its allocation over the years, keeping you in the right amount of stocks and bonds for your age, time horizon and risk tolerance. Just set it and forget it. Then wait for the target year to arrive and, like Rumpelstiltskin waking from a multi-year nap, you'll be ready for retirement.
Not so fast, please
During my 20 years as an adviser I saw target date funds grow from a new type of asset allocation fund into the half-trillion dollar business it is today. I also saw target date funds unintentionally misused.
This was not necessarily the advisers fault, or that of the investor, but the marketing of the products made them seem too good to be true; and they sometimes are.
You see, not all target date funds are created equally. They, like funds in other categories, can have similar names yet invest quite differently.
Knowing the specifics of your fund's investment approach is very important.
Today, with stock indexes and bond prices high and interest rates and bond yields low the future could hold unwanted surprises for advisers and investors ignorant of the inner workings of the target date fund they own.
Let's take a look at three fund families and their respective target date 2015 funds.
Since its inception Vanguard has been one of the low cost leaders in the fund business. It has remained true to its roots in its target date fund segment by utilizing index funds as the underlying holdings.
Morningstar calls Vanguard's target date fund offering "better than most" but the company's investment approach is common within the industry. Its funds stick to their strategic allocations. The fund management doesn't try to influence performance with tactical allocation shifts.
And Vanguard doesn't mess around with alternative asset classes either. Its funds are focused on three: domestic equities, foreign equities and domestic investment grade bonds. A TIPS index fund is added to the mix for investors near retirement.
Morningstar reports that Vanguard's target date 2015 fund has 59% of the portfolio committed to equities; the rest is in bonds and cash.
T. Rowe Price
T. Rowe Price has a higher allocation to stocks than does the average target date fund family. Investors in its 2015 fund are currently 61% in equities, 2% more than Vanguard.
Morningstar says T. Rowe Price's funds have been more volatile than its peers because of the greater allocation to equities. But this has also contributed to better returns.
Unlike Vanguard, T. Rowe emphasizes actively managed funds (86% of T. Rowe's underlying holdings are actively managed versus 3% for Vanguard) which have also contributed to the fund family's positive performance.
T. Rowe further differentiates itself from its peers by reducing the equity allocation of its portfolios for 30 years after the target date. Many competitors keep a static allocation once the fund has reached that point.
American Funds manages its target date fund lineup very differently than either Vanguard or T. Rowe Price. According to Morningstar the company takes a "non-traditional approach" by concentrating on "broad objectives such as "growth and income" rather than asset classes."
The standard for the industry is for fund companies to utilize modern portfolio theory to build their asset allocation strategies. But American Funds portfolio managers rely on their own experience to construct allocations that meet each funds loosely defined objective.
Not surprisingly, American Funds target date funds are 100% actively managed and rely heavily on its high quality lineup of proprietary funds.
American Funds target date 2015 fund has the lowest equity allocation of the three at 57%.
Know your fund
Morningstar ranks the target date fund families it reviews as gold, silver or bronze.
T. Rowe Price and Vanguard are the only fund families that received a gold rating from Morningstar. American Funds received a rating of silver along with three others: JPMorgan SmartRetirement Funds, Manning & Napier Target Funds and MFS Lifetime Funds.
But which is better? That depends on which fund's objectives match your objectives.
If the stock market breaks to new highs and keeps on going, as many analysts and pundits predict, then owning a more equity-heavy target date fund should prove advantageous.
Accordingly, conservative investors might be surprised to see their bond-heavy target date funds perform poorly as interest rates rise and bond prices fall.
The stock market might fail to reach new highs, however, and volatility could return forcefully. If so, an actively managed fund may be the better choice. They are generally more expensive than index funds but they can make tactical allocation shifts that might improve performance in volatile markets.
The bottom line is advisers should be having in depth discussions with their clients regarding the details of a target date fund before makig an investment and afterward as part of regular, periodic portfolio reviews.
Do-it-yourself investors should do their own research and familiarize themselves with many fund families before making an investment to ensure a proper fit.
Steven Orlowski has worked in the investment arena for twenty years as a high-net-worth financial planner, portfolio manager and trader. In addition to being a Certified Financial Planner™ he has held the following licenses: FINRA Series 7, 9, 10, 63, and 65 and various state Life and Health Insurance licenses.