Target date mutual funds and ETFs are investment products targeting a particular investment horizon through a fairly passive asset allocation approach. The year in each target date fund/ETF corresponds to the year in which investors may likely begin withdrawing assets. Currently, funds/ETFs with target dates Retirement Income (Today), 2010, 2015, 2020, 2025, 2030, 2035, 2040, 2045, 2050, and 2055 are available.
These target date funds/ETFs appeal to long-term investors because:
- Each represents a broadly diversified portfolio in a single fund that allocates among three major asset classes across U.S. and international equities, fixed income, cash and short-term investments,
- Ideal for investors who do not have the expertise to construct a well diversified portfolio,
- Each could be held as the only investment in the investor account or as a core holding to pair with other actively managed funds and individual stocks,
- Fund managers have great flexibility in constructing the underlying portfolio with 1) broad-based index funds to gain overall broad exposure (i.e. Vanguard Target Retirement Funds), 2) a combination of more narrowly focused index funds (i.e. Blackrock iShares), 3) a combination of actively managed funds to seek more fine-tuned style or interest rate risk exposures (i.e. American Century LiveStrong Funds), or 4) individual stocks or bonds (DBX Strategic Advisors)
- Equity risk exposure generally decreases while fixed income exposure increases as the target date fund/ETF approaches the target date. This is accomplished through monthly or quarterly rebalancing at the fund level by the fund managers.
Unlike other types of asset allocation funds/ETFs that are designed to maintain a steady risk exposure, the automatic risk-reducing characteristic of the target date funds/ETFs is an unique feature that imposes discipline on investors to take on incrementally less risk over time to ensure the success of their investment portfolio.
As the following chart illustrates, when a new target date fund is first created, its initial asset allocation is set at a predetermined equity risk exposure appropriate to its target investment horizon: 80% - 90% in most cases. Then as times go by, this equity risk exposure level of the target date fund will gradually decrease along the path. The drop in equity risk exposure will occur more precipitously in percentage terms as we approach closer to the target date. The current date and near term target funds (i.e. Today Fund and 2010 Fund) will still have a minimum amount of equity risk exposure set at 15% - 25%. This reflects the idea that investors needing current income or desiring low risk can still benefit from a small amount of equity exposure to take advantage of as much investing opportunities as possible.
(Source: Wells Fargo Advantage Funds)
In general, I would prefer target date funds/ETFs whose portfolio is made up of index funds because they tend to have a more predictable risk profile and track closer to the benchmark. In contrast, adding an active twist with individual stocks or actively managed funds can introduce additional unpredictable and unwanted risk to cause risk exposure to deviate meaningfully away from investors' desired level.
Although the target funds/ETFs are originally designed with targeting a particular investment horizon in mind, investors can apply the concept of "risk targeting" and utilize these target date funds to make tactical adjustments in a portfolio. As the actual amount of equity and fixed income exposure of each target date portfolio at any time is known or could be reasonably estimated, investors can rebalance their portfolios by simply exchanging the target date fund/ETF currently held in the account for a new target date fund/ETF that matches the new desired risk level. This adjustment could last temporarily and dictated by investors' short term market outlook or more permanently as investors' overall risk appetite shift. Since target date funds exist for almost every 5% incremental change in equity exposure, investors can either make gradual portfolio rebalancing (i.e. from Target Date 2035 to Target Date 2030) or carry out big changes (i.e. from Target Date 2025 to Retirement Income).
The more predictable risk exposure of target funds/ETFs constructed with index funds have an additional benefit of offering more granularity into the actual portfolio composition and hence provide investors with more control in managing risk when they make these tactical moves.
For example, each iShares S&P Target Date ETF is made up of eleven index ETFs that provides a clear picture of the different amount of equity and fixed income exposure to the macro factors that drive their performance such as market capitalization, geography, duration and sensitivity to interest rate risk, and credit risk.
Lastly, this tactical portfolio rebalancing strategy could be further enhanced by using target date ETFs because investors can trade in the open market, or create or redeem units with no general time restriction whereas mutual fund companies might impose redemption fee to discourage short-term trading.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.