Taking Aim at Target-Date Funds

Morningstar has introduced three new categories to handle the phenomenon of target-retirement funds. Fidelity rolled out one of the first series of these funds in 1996, but its Freedom funds faced little competition until T. Rowe Price entered the fray in late 2002; since then, many of the fund industry's bigger players have joined the party.

These funds, which previously tended to reside in the moderate-allocation, conservative-allocation, and large-blend categories, have very different mandates than their former peers. They're designed to serve as one-stop-shopping options for investors with a specific time horizon in mind. If an investor expects to retire in 29 years, for example, she might choose a fund with a target date of 2035. The funds, which typically hold other offerings from within their fund family, become more conservative over time; in order to provide more stability as retirement approaches, the advisor reduces a fund's equity weighting in favor of bonds as the target date draws near. Although most of these funds are designed for investors' retirement assets, we think they can also be a good place to stash college savings, too.

In order to provide better comparisons, we've split the funds into three groups: target-date 2000-2014, target-date 2015-2029, and target-date 2030+.

What to Look For
When sorting through these new categories, investors should keep in mind that competing funds with similar time horizons can have markedly different asset allocations. That's particularly true in regard to the funds' balance between stocks and bonds. T. Rowe Price, for example, strongly believes that investors should own significant equity stakes well into retirement due to the corrosive effects of inflation; thus,  T. Rowe Price Retirement 2005 (TRRFX) recently held 56% of its assets in stocks, one of the most aggressive stances among funds with that target date. On the conservative end of the spectrum,  Vanguard Target Retirement 2005  has just a 31% equity weighting. Thus, investors will need to consider their own risk tolerance and needs before making a choice--and should avoid relying too much on short-term relative performance figures when assessing these funds.

It's also worth noting that fund shops offering target-date funds have different ideas about what constitutes diversification. Some boast substantial weightings in foreign stocks: Putnam's longest-horizon funds stash 30% of their total assets in overseas equities. Many, however, provide far less foreign exposure than even the minimum 20% suggested by many observers. TIAA-CREF Institutional Lifecycle 2040 (TCLOX), for example, recently had less than 15% of its equity stake in overseas names. In a similar vein, some funds invest quite heavily in their large-cap-focused siblings--offerings from Fidelity, Vanguard, and Wells Fargo, among others, have more than 45% of their equity stakes in mega-caps. While that type of conservative positioning is fine for retirees, we'd like to see more longer-term funds boost their exposure to small fry, which have historically provided higher returns (albeit with greater volatility). Offerings from Putnam, State Farm, and T. Rowe Price, for example, delve further into small and mid-caps.

It's possible that some of the higher-cost entrants in these categories, such as Putnam's, own big stakes in foreign and small-cap stock funds in an attempt to overcome their cost disadvantage, while also allowing those shops to collect the higher management fees typically charged by those funds. But other target-date funds with wide-ranging portfolios, such as T. Rowe Price's series, sport reasonable price tags.

The Wheat and the Chaff
Because most of these offerings are funds of funds, it's vitally important that investors check out the underlying funds. Some fund shops take a kitchen-sink approach to target-date investing, including overlapping funds with varying merits. Fidelity, for example, tosses as many as 24 funds into the portfolios of its Freedom funds, including three large-blend and three large-growth offerings. We prefer target-date funds that invest only in a select number of their siblings; it's difficult to see the need for much more than a dozen underlying holdings. Of course, those funds should also boast accomplished managers, prudent strategies, and relatively low expense ratios. T. Rowe and Vanguard, in particular, manage to achieve broad diversification with a limited number of solid funds--their target-date offerings hold 10 to 12 and six to seven funds, respectively.

Finally, because target-date funds are meant to be held for very long periods, costs play a crucial role. Expense ratios for funds of funds often have two components--the price tags of the underlying holdings as well as any fees that the fund company charges for overseeing the aggregate portfolio. Some charge additional management fees for the minimal effort required to occasionally adjust their asset allocations, but the better ones don't. Many target-date funds from load shops hold their underlying funds' cheap institutional shares, then add in the requisite 12b-1 fee--which is often used to compensate brokers who sell the fund--at the upper level. That doesn't strike us as an objectionable practice, as long as the 12b-1 fee is reasonable. But given the often-hefty fixed-income weightings of target-date funds, investors should expect to pay less than they would for most pure-equity funds.

The lowest-cost offerings are (no surprise) from Vanguard, which uses only its ultracheap index funds in its Target Retirement series--thus, the funds' total costs are less than 0.25% per year, which make them very attractive choices. However, we're also impressed with T. Rowe Price's target-date funds, given the quality of their underlying holdings and their modest costs.