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Life-cycle funds with the same target date can have vastly different results
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The target-date fund concept
Target-date funds, also called “life-cycle funds” are retirement savings vehicles designed to switch from stocks to bonds over the course of years without investor involvement.
They work on the historical principle that in the long term stocks perform better than bonds, but recognize that stocks are intrinsically more volatile.
Consequently, conventional wisdom asserts that young investors should hold a greater percentage of their retirement portfolios in stocks. As investors age, and have less time to recover from the inevitable volatility of the equity market, they should slowly convert from stocks to stable bonds. Target-date funds provide that service and allow investors to “buy it and forget it.”
An investing rule of thumb is, “Take your age and subtract it from 100. The answer is the percentage that stocks should play in your investment portfolio at any given time.” Life-cycle funds follow a similar rule, but are more sophisticated in the application.
Target-date funds are keyed to investor planned retirement dates, e.g., a 2020 target fund will hold the formula mix of stocks, bonds, and perhaps cash, for an investor expecting to retire in or near 2020.
Why funds with the same target date perform differently
Unlike index funds, which automatically follow an index like the S&P 500, target funds are managed.
Inevitably, some fund managers are more successful than others because they select better performing stocks and bonds.
Target-date fund catch-up can have dire consequences
In the competitive world of fund management, if 2020 target-date fund “A” performs better than 2020 target-date fund “B”; the manager of fund “B” will feel the pressure to boost performance.
Investors put money into successful funds, and fund managers are expected to perform well – better than their peers, and give a good showing against whatever benchmark(s) they are measured against.
There are many ways for manager “B” to react. One way is to try to improve results by holding a greater percentage in stocks for a longer period. He would do so knowing that stocks perform better than bonds – over time. However, if the equity market tanks before the manager can make up the productivity differential, and adjust the stock to bond ratio, the manager – and more importantly – the investor will suffer.
What to do with a poor performing TDF
The simple answer is stay the course, or trade out.
Most target-date funds are held in qualified retirement accounts like 401(k)s and IRAs. It’s worth noting that trading within an IRA or 401(k) will not provide the investor with a tax advantaged loss if s/he sells because there is no opportunity to write off losses in a qualified account.
If fund holders are several years away from retirement, and still like the idea of a fund that holds both stocks and bonds, they can trade into another target-date fund, or a conventional balanced fund that has an established stock to bond ratio.
However, if investors move from target-date funds into balanced funds and want to convert stocks to bonds as they get older, they need to remember to manage their own stock to bond conversions as they near retirement age. They also need to remember that when they sell shares in a balanced fund, they are selling both the stocks and bonds held by the fund.
Investors that do decide to switch should look into unmanaged indexed-balanced funds. They will save some money on management fees – and every little bit helps.
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