Target date mutual funds provide a one-stop shop for retirement portfolios. The target date is the approximate date when investors plan to start withdrawing their money and you get an asset allocation that is geared to a specific retirement year. It then gradually gets more conservative as you inch towards that target date, a seemingly excellent investment solution.
The problem is that I hate most target date funds. Since I have been burned by them myself, let me be your Ghost of Christmas Future on this one. If not completely revamped, I predict that target date funds will eventually be relegated to the trash heap of once promising ideas like Betamax, Intellivision and New Coke. Below, are some examples I’ve observed over time that warrant caution:
1. They can get more aggressive as you age – This was my biggest WTH (What the heck??) moment. When trailing their benchmarks in a strong stock market, target date fund issuers have sometimes decided to make all of their portfolios more aggressive in order to “catch up”. It is their way of keeping up with the Joneses. However, it leaves you with a portfolio that becomes riskier as you get older when you may not be able to take on this higher risk.
2. They’re living in the past man – Target date funds are often skewed towards asset classes that have performed well over the past 5-10 years. I wish there was a way for investors to capitalize on an investment’s past performance, but there isn’t. The most common investment disclaimer is that “past performance is not indicative of future results.” Truer words have never been spoken (and kudos to the attorney that came up with this). Currently, most target date funds are very heavy in US stocks and US bonds, two of the strongest performing asset classes since the financial crisis. They tend to be very under-weighted in international stocks and bonds and have almost no exposure to inflation-fighting asset classes.
3. Their risk tolerance may not be your risk tolerance – For a given target date, the stock exposure of different funds can vary by as much as 20-30%. Some mutual fund families believe that your allocation should be fairly conservative when nearing retirement (low exposure to stocks), while others believe you should be fairly aggressive (high exposure to stocks) since an average person may spend more than 20 years in retirement. The message from this is that you better look under the hood of your target date investment or you may be taken for an unanticipated roller coaster ride in a bumpy market.
4. Are you feeling lucky? – Target date funds are designed to incrementally reduce their exposure to stocks each year. However, if markets remain depressed for several years (not historically unprecedented), you will be selling your stocks at the absolute worst time and won’t have enough stock exposure when the market bounce finally occurs. Essentially, you bought high and will be selling low. Target date funds only “work” if you are lucky enough to buy them when markets are rising and don’t experience any protracted declines during your investment horizon.
Okay, I don’t hate every target date fund (but I hate most of them). Not all fund designs are poor and they can be useful for smaller investments. However, I would proceed with caution when betting a large part of your nest egg on this type of product.
* The principal value of a target fund is not guaranteed at any time, including the target date.
* Investing in mutual funds involve risk, including possible loss of principal.