Why Target-Date Funds Are Off-Target for Many Investors

published 3 August 2012

Analysts once called companies like General Electric and Xerox “one-decision stocks”—buy ’em and forget ’em, then reap the benefits years later. Today, target-date mutual funds are one-decision retirement plans. But just like simple solutions to other complex problems, they have pitfalls. I’m not against these funds, but most are far from perfect.

Still, at a time when investors are turned off by stock mutual funds, it’s no surprise that target funds are outrageously popular. With a single purchase, investors have an amazingly handy way of constructing an evolving lifetime portfolio—in many cases, one with low fees.

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A target-date fund typically consists of other mutual funds and exchange-traded funds. What makes a target fund different from other funds of funds is that the fund’s portfolio shifts over time. As you get closer to retirement or some other milestone (that is, the “target date,” such as 2030, that’s in a fund’s name), the fund becomes less risky. When you hit the date, you don’t have to sell—most of the funds are built to be held during retirement, too (see When a Target Fund Nears Its Target).

Most target funds reduce risk by slowly changing their allocations of stocks, bonds and cash over the years, a feature known as a glide path. For example, Vanguard Target Retirement 2050 (symbol VFIFX), geared to people retiring in about 40 years, currently allocates its assets this way: Nearly 90% in stocks, 10% in bonds and virtually nothing in cash. Vanguard Target Retirement 2015 (VTXVX), whose investors are on the brink of retiring, holds 55% in stocks and 45% in bonds.

The reason is that a portfolio’s risk is determined not only by the risk of each asset class but also by how correlated those classes are. That is, investing in assets that tend to move in lock step will produce more-volatile returns. But when two assets have lower correlations, one might lose 30% in a given year, but the other gains 10%. So, assuming you had half of your portfolio in each, you’d lose 10%—not the 30% you’d lose if the assets were tightly correlated.

Unfortunately, we live in an era in which correlations across many major categories of investments are high. You have to search hard to find low-correlation asset classes—and you must be mindful that these relationships can change. (Lately, for instance, when stocks fall, Treasury bonds rise in price, in part because U.S. debt is seen as a safe haven in tough times. But in the past, stocks and bonds have gone up and down in tandem—a pattern that might reassert itself.)

The best way to reduce risk may be by owning a portfolio that, on the surface, appears to have little coherence. For instance, a portfolio assembled by Folio Investing, Target 2025 Moderate Folio, has 85% of its assets in five ETFs holding small-company stocks, energy stocks, long-term Treasury bonds, commodities and insured municipal bonds. Much smaller amounts are in ETFs that focus on real estate trusts, emerging-markets stocks, technology shares and corporate bonds.

Instead of creating a glide path based on asset allocation, Folio’s strategy targets risk alone. Its computer-driven analysis finds the right mix of ETFs that will, for example, carry 80% of the risk of the S&P 500 when an investor is 15 years from retirement and 50% of that risk at retirement. Of course, altering a portfolio’s level of risk will almost always cause its asset allocation to shift as well.

The approach doesn’t have much history yet, but it seems to work. Folio Investing says that from the start of 2008, when it launched the Target Folios, through June 30, 2012, its moderate portfolios consistently outpaced the average results of its three largest mutual fund rivals. As an example, Folio’s moderate 2030 product returned an annualized 2.2% over that period (after fees), while the 2030 funds offered by Fidelity, T. Rowe Price and Vanguard gained an average of just 0.1% annualized over that period.

I like that Folio offers three levels of risk for each date. For my taste, most conventional target-date funds take on too much risk. For example, T. Rowe Price Retirement 2030 (TRRCX) has 83% of its assets in stocks. I think someone retiring in 2030 should have no more than 60% in stocks. (One way to mitigate this problem is to own a fund with a target date ten or 15 years in advance of your actual retirement date.)

One drawback to Folio’s approach is that its portfolios can be mystifying. The Target 2020 Conservative Folio has 15% of its assets in a global technology ETF, and many of the folios hold municipal bonds. Folio CEO Steve Wallman, a former commissioner at the Securities and Exchange Commission, says the portfolios include munis because they do not track other assets closely. By contrast, the Target Folios don’t own any ETFs that track the S&P 500 index or focus on value stocks.

When the going gets rough, investors often panic and make mistakes. One reason I find the Target Folios so appealing is that they offer investors the potential of a smoother ride than traditional target funds without any fall-off in results. I’d like to see the larger target funds move in Folio’s direction, by focusing on risk, not merely asset allocation, and becoming more conservative. Until they do, be wary.

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James K. Glassman is a visiting fellow at the American Enterprise Institute. His most recent book is Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence.