Target-Date Funds: Buyer Beware

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 |  Includes: SPY
by: Matthew Frankel

Target-date mutual funds have grown exponentially in popularity over the past few years. Since 2008, target-date funds have brought in $177 billion in cash, giving them a total of $380 billion under management. In 2005, there was only $71 billion in target-date funds. They have become dominant components of many 401k plans, as well as in IRAs for those who want a "maintenance-free" investment strategy.

Target-date funds are intended to be a proactive investment strategy that requires very little work. For example, somebody like me who has a target retirement date of 2040 would buy a fund of that target, say, the Vanguard Target Retirement 2040 (MUTF:VFORX), which has a very low 0.19% expense ratio. This fund currently has 63% of assets invested in U.S. stocks, 27% in international stocks, and 10% in bonds. As my retirement date gets closer, the fund will rebalance itself to create the "ideal" balance for my age and supposed risk tolerance.

However, recent studies show that target-date funds underperform the overall market. The Vanguard fund, for example, has returned 10.59% YTD, compared with 13.51% for the S&P 500. That may not sound like much, but a 3% annual underperformance can lead to a huge difference over a 30-year period. Similarly, its 3-year annualized return is 10.65%, versus 13.62% for the S&P.

These types of funds vary greatly in terms of fees and portfolio makeup depending on the particular fund, so buyers do need to shop around and compare to their particular goals and risk tolerance. For instance, funds with a 2015 target date range from 63% to only 20% of holdings in stocks. For comparison sake to the Vanguard example, let's also look at the T Rowe Price Retirement 2040 Fund (MUTF:TRRDX). This fund has a higher expense ratio of 0.76% as compared to the Vanguard fund. This fund has a very similar makeup to the Vanguard fund, with 89.5% in stocks and 10.5% in bonds. Performance has been about the same also, with returns of 11.7% YTD, and 11.59% over 3 years. This is about 1 percentage point better than the Vanguard fund, but a full 2% below the S&P.

As an example of how these funds can differ significantly in makeup, Fidelity's Freedom Index 2040 Fund (MUTF:FBIFX) allocates only 72% of its portfolio to stocks, and the rest into fixed income securities. This fund is too new to compare long-term performance, but YTD it has significantly underperformed the market, with a 9.33% return, the lowest of the 3 funds we have looked at.

Even the funds that are meant to be ultra-safe for those close to retirement can be anything but. In 2008-2009, during the financial crisis, one would think funds like the Vanguard Total Retirement 2010 and Fidelity Freedom 2010 would be relatively safe, invested in mostly investment-grade bonds and other similar fixed income instruments. On the contrary! These funds lost 26% and 29%, respectively, over a 12-month stretch between these two years. Bear in mind that the investors in these funds were a year from retirement!

In conclusion, these target-date funds do what they are intended to do. They take the guesswork out of investing, eliminate the need to try to time the market, and provide a generally easy plan for the average investor's retirement. If this is the only type of investment your employer offers that is appealing, then absolutely max out your 401k. Slightly lower than market returns will be made up for by your employer's contribution to your account. However, for retail investors' accounts, the historical data suggests that simply buying an S&P index fund (like SPY) is a much better passive retirement strategy than a target date fund. Another strategy would be to put all of your savings into an S&P index fund while you are young, and then gradually buy shares in bond funds as your risk tolerance decreases over time.

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.