Mon, 27 Jan 2014
Target-date funds can be well-suited to investors who lack the time or desire for more hands-on portfolio management, but they still need to so some homework first, says Morningstar senior fund analyst Josh Charlson.
Adam Zoll: For Morningstar, I'm Adam Zoll.
Target-date funds have gained lots of attention as a retirement savings vehicle, but are they right for you?
Here to talk about this question is Josh Charlson, a senior fund analyst with Morningstar who specializes in funds of funds.
Josh, thanks for being here.
Josh Charlson: Happy to be here.
Zoll: First, let's talk about what we mean when we say a target-date fund. How do target-date funds work, and what purpose do they serve?
Charlson: The basic principle of a target-date fund is that it's a very diversified portfolio combining a lot of asset classes, usually a lot of underlying funds, and it's going to manage the allocation for the investor [to those asset classes] over time.
Each year there is a gradual roll down of the equity [allocation], so over time as the investor ages, you are going to get more in bonds, less in stocks--sort of adjusting that risk profile appropriately.
Zoll: We often use the term target-date "series" because we are talking about a series of funds based on the investor's expected retirement age.
Charlson: Right. You are going to choose a fund has the date that's close to your expected retirement date, and then you are going to get that allocation managed for you. Along the series, there is a bunch of funds with different dates, usually in five-year increments, and there is what we call a glide path, and that's really the shifting of the asset allocation over time.
Zoll: The target-date fund is sort of an all-in-one investment, right? What sort of investor is this ideally suited for?
Charlson: It's really potentially suited for almost any investor. It's become very popular in 401(k) plans. It's often the default investment for employees who are starting out in a firm. It's very appropriate for investors who don't want to spend the time, or don't have the knowledge, to do a lot of active allocation for themselves. It is potentially less effective or less appropriate for investors who are either more sophisticated, more do-it-yourselfers who want to do a lot of allocation themselves, or maybe who have a more complex portfolio of outside investments as well.
Zoll: If you like this all-in-one solution that a target-date provides, does that mean that you cannot put investment money in other satellite holdings? In other words, if you're in for a penny, are you in for a pound, and you have to stay with your entire allocation in that target-date fund?
Charlson: It's an interesting question. In the ideal, optimal world, they are designed as a single investment, and they can certainly function that way very well. But there have been studies--for instance, Vanguard looked at its participants and found that a lot of them did hold other investments outside of their target-date funds, and they still had better investment outcomes than if they were just trying to manage the investments on their own.
So I think if you do it smartly, there is nothing wrong with having some additional investments if you want exposure to a certain area that perhaps your target-date fund doesn't have exposure to; it could be emerging-markets stocks or something like that.
Zoll: And you mentioned the five-year increments. If you want, say, a heavier equity allocation or a more conservative investment allocation, can you tinker with which target-date [fund] you actually use?
Charlson: Yes. That's certainly acceptable. If you believe that your risk profile is a little different from what the allocation looks like for a certain date, you could expand the date by five years or 10 years, or bring it in if you wanted a slightly different profile.
When we are talking about the funds for investors who are 25-30 years from retirement, the allocations tend to not be very different. The stock allocation is the same. It's when you get closer to retirement that those … allocations are going to vary a bit more.
Zoll: Let's talk about performance. If I'm choosing a target-date fund for 2020, and for all the different funds that have a 2020 target-date, is the performance likely to be pretty similar or are there going to be variances there?
Charlson: There are going to be variances, and a lot of the performance is driven by the asset allocation. That's by intention. That's the way the managers want these funds to work, [with] the asset allocation [driving] a lot of the performance. So when you look at that equity-bond mix, that's going to drive a lot of the performance.
We have what we call more aggressive glide paths, or equity-heavy glide paths, where there is more in stocks all along the way toward retirement, and there are more conservative ones. When the stock market is up a lot like in the year 2013, you are going to see the funds that were more aggressive did better. Their performance really approached what the developed stock markets did. The ones that are more conservative maybe lagged a little, but those are the ones that tended to do better in 2008 or 2011.
Zoll: And I take it that you would advise people to really understand how the target-date fund works, so that they don't just blindly invest in this, but understand what their equity exposure is, for example.
Charlson: That's key. It is a leave-it-alone type of investment, but I think going into it, you need to make a little investment of your own time to say, is this right for me? Does the allocation matchup, not only where I am today, but where I think I'm going to be 30 years from now. Does that look like something that my risk profile can tolerate? That might change. So you should re-evaluate it over time, but you want to go in knowing what you have.
Zoll: Josh, thanks so much for providing your insights today.
Charlson: Thank you.
Zoll: For Morningstar, I'm Adam Zoll. Thanks for watching.