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Off Target

Greg Spears, 4:11 am ET

NEW RESEARCH suggests that target-date retirement funds—which currently receive a majority of contributions to 401(k) plans—are missing the mark.

Target funds’ returns, in aggregate, lagged those of replica portfolios built with exchange-traded funds (ETFs) by one percentage point a year, according to University of Arizona finance professor David C. Brown, one of the study’s authors.

The majority of the underperformance was due to higher fees, Brown said. Target-date funds are funds-of-funds. Most fund families charge investors layers of management fees—both on the target-date fund itself and on the underlying funds.

Active management also cuts into target funds’ returns, according to the study. Active managers, as a group, tend to lag the market averages. The good news: Some target-date funds have some or all of their assets in market-tracking index funds.

Finally, the timing of asset allocation adjustments was a small reason for target funds’ performance lag, accounting for about 1/20th of the return difference, according to the study.

Brown’s study, co-authored with the University of Colorado’s Shaun Davies, is titled “Off Target: On the Underperformance of Target-Date Funds.” It was presented Nov. 12 at a conference sponsored by the CFP Board Center for Financial Planning.

To assess target funds’ returns, Brown and Davies mixed replica portfolios using 50 low-cost, passively managed ETFs from Vanguard Group. Their performance was compared to equivalent target funds from 2008 to 2020.

“In dollar terms, target-date funds underperformed cumulatively by $35 billion,” Brown said. The underperformance reached nearly $10 billion in 2019, as target funds’ assets grew to almost $1.6 trillion.

Many workers are automatically invested in target funds when they’re enrolled in their employer’s 401(k) plan. Employees can change to other plan investments, but relatively few do. Target funds receive nearly 60% of all plan contributions, according to Cerulli Associates.

The relatively poor performance of most target-date funds may sound disturbing. But before target-date funds took off, many 401(k) plans used a money-market fund as the default investment option—and many participants never changed investments, so they ended up with miserably low investment returns. By contrast, owning a mediocre target-date fund is arguably a big step in the right direction.

What can today’s investor do?

The best scenario: Be lucky enough to have a good fund family supply the target funds in your 401(k), Brown said. Vanguard’s target funds lagged the study’s ETF replica portfolios by just 0.01 percentage point a year. Full disclosure: I worked for Vanguard until I retired last year.

Otherwise, Brown suggested investors could build their own replica target funds by mixing six ETFs—U.S. stock, U.S. bond, international stock, international bond, inflation-indexed bond and real estate.

There are problems with this approach, however. As of 2018, only 21.5% of 401(k) plans offered a brokerage window that would allow participants to buy ETFs, the study noted. It also assumes a level of interest that many 401(k) investors don’t possess.

Alternatively, you could simply invest in a set of low-cost index funds—again, assuming they’re available through your 401(k) plan. Not sure what mix to buy? You could take your cues from a target fund geared to a retirement date similar to when you plan to retire.

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Ormode
Ormode
7 months ago

You haven’t seen anything yet. If bond yields should go up 200 basis points, bond funds would go down hard, and the S&P 500 would do the same thing. These changes would cause of a lot of collateral damage in the economy as well.

Joey
Joey
7 months ago
Reply to  Ormode

Maybe, but that doesn’t have anything to to with whether Target Date funds trail replica model portfolios, which is the point of the article

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