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ALBERT EINSTEIN reportedly once said, “Everything should be made as simple as possible, but not simpler,” or words to that effect.
When it comes to investing, I have always believed that the simplest approach is the best approach. But in recent years, a new type of investment has, I believe, crossed over into the “too simple” category.
This new type of investment: target-date mutual funds. If you aren’t familiar with them, target-date funds are mutual funds that typically buy other funds. For example, a target-date fund might be comprised of stock funds and bond funds, with the specific mix geared to one’s expected retirement date, which is the target date specified in the fund’s name. For workers early in their career, the mix might be 90% stocks and 10% bonds. But over time, as the worker gets closer to retirement, the composition will shift, automatically becoming more conservative. Owing to their simplicity, target-date funds have seen sharp growth over the past 10 years.
In theory, this type of all-in-one offering is very appealing. But there are four reasons I would be cautious about investing in one:
First, target-date funds make it difficult to know what you own. Research has shown that the most important driver of a portfolio’s risk and return is its asset allocation—that is, the mix of stocks, bonds and other assets. As a result, asset allocation is arguably the most important portfolio metric to monitor. But target-date funds make it difficult to track this key metric because they contain a mix of asset classes—and, worse yet, a mix that’s constantly changing.
Second, the composition of these funds may be a poor fit. Choosing an investment based on your age is like choosing clothing based on your age. It might be okay when you’re an infant or a toddler, but it makes little sense as you get older. Yes, there is some correlation between age and investment needs, but your age is just one piece of the puzzle. Other factors include: the size and composition of your other assets, your eligibility for Social Security or a pension, your spouse’s retirement timetable, whether you expect an inheritance and much more.
Third, they complicate tax planning at every stage of your career. Suppose you have a 401(k) and a taxable account and you want to purchase $1,000 of stocks and $1,000 of bonds. Should you put the stocks in your 401(k) and the bonds in your taxable account, or the other way around?
Even though you would be purchasing the same investments in either case, the decision would have a big impact on your tax bill. In many cases, investors will find they’re better off pursuing tax-efficient stock strategies in their taxable account, while holding bonds in their retirement account. This sort of asset location is a valuable tax planning strategy. But by creating an inseparable link between stocks and bonds, target-date funds hamper your ability to employ it.
These tax problems become especially thorny as you get older—assuming you hold a target-date fund in a regular taxable account. The funds assume you’ll want to sell stocks and buy bonds as you get closer to retirement. For many people, this will make sense. But suppose you don’t want to do that. Maybe your portfolio is large enough that you can afford more risk. Or maybe you have a pension or other secure sources of retirement income. In all of these cases, the target-date fund will be working against you, selling assets and generating unnecessary tax bills.
Target-date funds might also work against you once you enter retirement—again, assuming you hold your fund in a taxable account. Suppose you want to withdraw $50,000 to meet your expenses this year. To minimize the tax impact, you would want to sell investments that have the smallest unrealized gains, and perhaps simultaneously donate to charity those investments with the greatest unrealized gains. For most people, this might mean selling bonds and donating stocks. This is a powerful strategy. But when you own a target-date fund, your ability to do this is limited because of that inseparable link between stocks and bonds.
Finally, target-date funds often carry higher fees. In many cases, target-date funds are no more expensive than their component parts. That’s as it should be. But I have seen several cases in which target-date funds were considerably more expensive than their constituent parts. Like paying $3 to buy two $1 bills, this sounds illogical and I would even call it unfair, but it happens.
Fortunately, there’s a solution: If you are considering a target-date fund, instead simply purchase the constituent funds independently. While this will require a little more effort, I believe it’s well worth it.
Adam M. Grossman’s previous articles include Just Like Warren, Any Alternative and Buy What You Know. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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Second, in what sense do target-date funds “make it difficult to know what your own?”
a) If you literally own nothing but a target-date fund, then you can look up anything you want to know about its performance or composition in one step, on Morningstar or reading the fund’s own materials.
b) If you own several different funds, you need to set up a spreadsheet or do a Morningstar X-Ray or something… and there is no difference at all between owning several different non-target funds and owning a target fund and some non-target funds.
c) It’s no easier to interpret the “manager’s letter” or semiannual reports or “statement of additional information” from a target-date fund than any other mutual fund. Indeed, if the other funds are actively managed and the target-date fund is a portfolio of index funds, it is easier.
While there’s merit in some of the issues raised, methinks thou doth protest too much.
Target date funds are designed for those who don’t want to think about their investments, who don’t want to monitor them. (And if they do, all they have to do is check the glide path in the prospectus.)
They are best used as “all in” investments. If one mixes and matches target date funds with other investments, the point of using them is lost. Admittedly there are some assets that can’t be rolled in, like SS and other lifetime income streams (annuities, pensions). So when one initially selects a glide path, one takes these into consideration. A one-time-only task, as opposed to continual monitoring. Again, for those disinclined to manage their investments.
There is something to be said for separating stocks and bonds for tax purposes. Though the same argument can be made against all allocation funds, including traditional, statically allocated balanced funds, such as Vanguard Wellington.
Arguing that because there are a few bad apples (that add a second layer of fees) one should avoid the category altogether is specious. It is like saying that because some index funds carry loads or come with high fees, one should avoid index funds entirely.
Finally, nearly half of households with investment accounts own only retirement accounts (33% hold taxable accounts, 29% retirement only, the remainder no investments). For them, tax issues are moot. They are also less likely to be financially literate and thus more likely to benefit from a target date fund. For them, target date funds are not too simple.
Data in the preceding paragraph come from FINRA (2015):
https://www.finrafoundation.org/files/snapshot-investor-households-america
I wrote about TDFs back in July and raised many of the same concerns as Adam:
https://humbledollar.com/2018/07/one-and-only/
But I take a somewhat kinder view than Adam, in large part because of the behavioral issue. TDFs aren’t ideal — but for many investors, they are indeed the right solution.
“Target-date funds make it difficult to know what you own.” First, that’s not a bug, that’s a feature. That is to say, people using all-in-one funds are more likely to be looking at the performance of their portfolio as a whole, and not overreacting to recency (e.g. not piling into emerging markets in the previous decade or bailing out of them now).
I use target date funds in my 401-k for the simplicity. I do, however, tweak it by pushing the target date well beyond my actual anticipated retirement date by five years. The thought is that it makes it somewhat more aggressive. And I have a whole bunch of other retirement money with a financial adviser. The 401-k will likely represent 10% of my entire investments at the point of retirement.
Thoughts?
That seems like a reasonable strategy. You should make sure your advisor knows what target-date fund you own. But in all likelihood, it won’t change how the advisor manages your other money, because the target fund is well-diversified — and hence the mix probably isn’t too different from what the advisor has recommended.