Target-date funds can be the right choice if you're this kind of investor
By Anora M. Gaudiano, MarketWatch , Ryan Vlastelica
When it comes to investment products, the ones that get the least attention turn out to have the best investor returns, according to Morningstar.
Enter target-date funds, which have grown to nearly $900 billion under management by the end of 2016 since first launching less than 25 years ago.
A target-date fund, also known as a life-cycle fund, is a mutual fund with a mix of assets -- typically stocks and bonds -- structured to become less risky as investors approach retirement age. Returns are never guaranteed, but depend on how markets perform.
For example, a target-date fund for 2050 will have a much higher allocation to equities than a fund with 2020 date.
Because of behavioral mistakes, such as buying funds at market tops while chasing returns and abandoning them during downturns -- commonly known as buying high and selling low -- investors tend to underperform their investments or have a negative return gap.
Read: Why advisers say tactical allocation funds usually aren't worth the fees (http://www.marketwatch.com/story/why-advisers-say-tactical-allocation-funds-usually-arent-worth-the-fees-2017-03-23)
But Morningstar's Annual Mind the Gap study found that such self-defeating behavior generally hasn't been seen within target-date funds. In fact, investors who use target-date funds as their sole investment do even better than the funds themselves. The investor return gap in this case is positive.
The reason behind such results has to do with the design of target-date funds that encourages investors to buy and hold for long periods and have a hands-off approach to investing.
"The kind of people who favor target-date funds are also the ones who favor systemic or a rule-based approach to investing," said Dana D'Auria, director of research at Symmetry Partners, a Glastonbury, Conn.-based asset manager.
Morningstar analyzed investor returns of 18 target-date series that have been around for at least the past decade through the end of 2016 and found that the asset-weighted average 10-year return was 5.4% and average target-date return was 4%.
In the table below, Morningstar study found that in all other categories, investors underperform the products they invest in.
While some may question the modest 5.4% return, it should be noted that target-date funds are designed to be less risky or with heavier bond allocations as investors age and are closer to withdrawing. As such, on absolute terms they will have lower returns than equity mutual funds, as can be seen from the table above.
"The positive return gap of 1.4 percentage points is a remarkable achievement by investors, who normally underperform their investments due to behavioral mistakes," according to Wyatt Lee, portfolio manager at T.Rowe Price.
"Investors' needs and goals are different, so coming up with a single product based solely on one factor -- age -- is not going to be optimal for everybody. Yet, the nature and design of target-date funds makes them a much better option than planning their own asset allocation," Lee said.
In fact, those who wish to choose non-target-date asset-allocation funds have a wide variety of choices, including exchange-traded funds.
Asset-allocation funds are similar to target-date products in that they offer different types of assets -- typically, a combination of stocks and bonds -- within the same wrapper. Where they differ, however, is that while target-date funds shift over time, the holdings of an asset-allocation fund remain static, though rebalanced annually.
Tactical-allocation funds may see more frequent rebalancing, with managers intent on taking advantage of changing market environments.
Depending on aggressiveness of the funds, the allocation to stocks in these funds can range from about a third to as high as 80%-plus.
"These are one-ticker solutions for building complete portfolios that allow you to own your own specific risk appetite," said Danny Prince, head of product consulting for the iShares wealth advisory business.
Read: Here's the latest proof that complexity in investing tends to hurt returns (http://www.marketwatch.com/story/heres-the-latest-proof-that-complexity-in-investing-tends-to-hurt-returns-2017-06-14)
While the popularity of target-date funds has grown, so has criticism, especially in the academic world, according to D'Auria.
The main problem with the target-date funds is the ending allocation.
"It is difficult to determine the absolute best ending allocation that would fit across different markets. For example a 30% equity and 70% bond allocation for someone who is retiring may not be the best in a year like 2008," D'Auria said.
Other disadvantages of target-date funds have to do with them being one-dimensional -- as they only take an investor's age as a parameter, they could be suboptimal.
Still, as a one-stop solution that could benefit investors who cannot afford financial advice target-date funds achieve what most other funds don't --sticking to a plan.
"Those who have financial advisers can get a tailor-made portfolio that takes into account their age, risk profile, goals and needs. But in the absence of an adviser, target-date funds make a lot of sense for investors saving for retirement," D'Auria said.
-Anora M. Gaudiano; 415-439-6400; AskNewswires@dowjones.com
(END) Dow Jones Newswires