Be cautious of target funds


As we enter the time of year when we begin to plan for the next, many are wise to turn their attention to their employer-sponsored Defined Contribution Plan such as their 401k, 403b or 457 (NYS Deferred Compensation.) Today, 75% of American workers have to save for their retirement via one of these vehicles while only 25% are covered by a Defined Benefit Plan or one that guarantees a certain level of monthly income. This is a mirror image of twenty-five years ago when nearly 75% of American workers were covered by Defined Benefit Pension Plan while only 25% saved for retirement via a Defined Contribution Plan.
Mutual funds that spread your investment over different asset classes based upon your time horizon, more commonly known as target, lifecycle or age-based funds, are rapidly growing in popularity, especially in these plans. The offerings are easy to identify as many contain the “target” year in the name of the fund. Generally speaking, the target year should coincide with the year in which the investor expects to retire. For example, if you are age forty and you expect to retire at age sixty-two, a Target Retirement 2040 Fund might be appropriate.
Given the above, it is wise to become familiar with the benefits of investing in these funds as well as what we believe are a couple of potential pitfalls.
Target funds appeal to the retail investor as they provide one-stop shopping. The larger funds such as Vanguard, Fidelity and T. Rowe Price offer online questionnaires to aid in selecting the appropriate fund to meet your needs and conform to your risk tolerance.
Most target funds are “funds of funds” meaning that they invest in other mutual funds within the same fund family to, hopefully, achieve greater diversification as compared to investing in individual securities.
Target funds can also be separated into those that are either active or passively managed. Active refers to a strategy in which a professional money manager or team of managers select specific investments in accordance with the objective of the fund. Passive refers to a method of investing in which the underlying investments correspond with a specific market index.
One final benefit of investing in these funds is that as the investors approach his or her target date, the fund gradually becomes more conservative by automatically rebalancing or transitioning a larger percentage of the holdings within the fund to bonds as compared to stocks. Although capital appreciation becomes less likely, volatility and also the chance of loss also is reduced.
In our opinion, the major pitfall to investing in target funds pertains to the international equities contained within the fund as a percentage of the total assets of the underlying fund. According to the most recently published data from Morningstar, the international equities contained within the “2040” offering from Vanguard, Fidelity and T. Rowe Price are 33.4%, 29.6%, and 28.3%, respectively. The net result, of which the average investor may not be aware, is severe underperformance in relation to the S&P 500, this despite having more than eighty percent of fund assets in equities. As an example, the trailing year-to-date, one, three, five, and ten-year returns of the Vanguard S&P 500 Index Fund (VFINX) are 9.40%, 15.10%, 15.44%, 13.44%, and 12.38% where the returns of the Vanguard Target Retirement 2040 Fund (VFORX) are 2.32%, 6.52%, 10.69%, 8.68%, and 9.56%, respectively. (Please note that returns more than one year are annualized.)
Another area that requires due diligence from the investor includes asset allocation. For example, the Vanguard Target Retirement 2020 Fund (VTWNX) has more than 50% of its assets in equities of which, 40% of that is invested in non-U.S. stocks. Five years further out, the Vanguard Target Retirement 2025 Fund (VTTVX) has a little over sixty-one percent invested in equities. Make certain that you consider this when allocating assets into target funds.
Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial advisor. Please note that Fagan Associates, Inc. or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial advisor prior to making any changes to your portfolio. To contact Fagan Associates, Please call 518-279-1044.


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