Pros and Cons of Target Date Funds (TDF)
Are you considering a "target date fund" (TDF) as an investment? If so, you need to consider some things before investing in one, much less selecting one. Right from the start, if you have all of your assets in a single account, then a TDF may make sense for you. If not, then there are numerous factors you need to consider before investing in one.
To begin with, there are two distinct ways in which you can invest in a TDF, the more common mutual fund or an exchange-traded fund (ETF). Both of these investment types are considered a fund of funds, and this merely means that each invests in a group of other mutual funds or ETFs to comprise the TDF itself. A TDF can be passively managed, meaning it will invest in other mutual funds or ETFs that are considered index funds, meaning they track a fixed index, and their returns are meant to mirror the index they track. Or the TDF can be actively managed where a fund manager selects a variety of mutual funds or ETFs to invest in and is designed to attempt to maximize returns and not accept an indexed return. For this post, we will refer to either mutual funds or ETFs simply as a TDF.
First, we will look at the pros of a TDF.
Easy and Simple to Use
Using a TDF is meant to be more of a one-stop need for a portfolio as a TDF will invest in a mixture of equity and bond funds, being more aggressive when you are younger and becoming more conservative as you near your retirement date. All you need to do is select a target year for your retirement and invest regularly.
As a general rule, a TDF will invest in various equity funds or indexes, domestic and international. They can also invest in various equity classes from large to small-cap, from international developed to emerging markets. Then there are the bond funds that can be used from government debt to bonds considered junk. What is used in the TDF will depend on if it is active or passively managed.
With a TDF, you do not need to worry about investing, which is left to the fund's manager. And in conjunction with the diversification, the risk is also reduced as your funds are spread out over numerous asset classes that will automatically adjust based on your time horizons, not the market's actions. The only thing you need to worry about is your amount, not what it is invested in. My advice is to invest on a schedule or predetermined date and stick to that schedule no matter what. You may want to add to your predetermined amount if the market is down at the scheduled date but never less than what your plan calls for, regardless of whether the market is up.
Reduces Your Work
With a TDF, you merely need to research which TDF to select and use and then, for the most part, forget what you have. If you invest in individual stocks or funds, you must do your research regularly to ensure that the investment is still worthy of owning. With a TDF, the only thing you need to concern yourself with is the fund manager if it is an actively managed TDF. And to a degree, the TDF charges fees, but they should notify you in the event of a fee change but not necessarily the change of the fund's manager.
The cons of a TDF.
Loss of Control
If you have trouble giving control of your investments, then a TDF may not be for you. When investing in TDFs, the only control you have is selecting the fund and its associated family and your retirement target year, and the rest is up to the fund and its manager. There is an amount of control concerning asset allocation by selecting different TDFs and comparing their investment styles to be more or less aggressive.
Here the fund's manager determines what level of risk you are taking at each stage of your career. This is why it is important to look at various TDFs and their style to determine which will be the best fit for you and your risk tolerance. Again, just like with the control, you can select a variety of TDFs to examine to see where they are in their asset allocation and adjust from there. You can also examine the TDFs strategy on asset allocation at different stages of the fund's lifecycle.
It is important to know the manager's style and fund families he will select from in developing the TDF for actively managed TDFs. For passively managed funds, the same applies but will generally be limited to the family of the TDF, such as all Schwab funds would be used in a Schwab TDF. Examine the funds that could comprise the TDF as not all fund families are as productive and fee friendly as others.
Here it is important to understand the structure of the TDFs fees. Most passive TDFs will add up the individual fees of the funds held in the TDF, and that is your management fee, such as Vanguard TDFs. However, some passively managed funds and all actively managed funds will also include a management fee on top of the combined fees of the individual funds. This is where it is important to understand the nature of the fees associated with a TDF.
This is extremely common with actively managed mutual funds and TDFs, chasing performance returns. It can also be an issue for passively managed funds but not to a large degree as the fund's family, asset allocation, and target date will impact the return on a passively managed fund. But when it comes to actively managed funds, there can be a wide range of returns from year to year as the manager is chasing the best returns they can and is not accepting an index's returns.
As with any investment, there are two things always to consider, and they are 1. Investments can decrease in value, meaning you lose principle, and 2. Past performance does not indicate what the future performance may be. Always remember these two points!
If all your investments are in a single account, your asset allocation is fairly easy as it will be the TDFs allocation unless you have other investments. That is not to say you can only have a TDF because it means nothing of the sort. By owning a TDF, you must be aware of the asset allocation within the TDF and when it rebalances and use those balances with your other assets to ensure you stay within your investment plan and risk tolerance. It takes some work, but it is manageable if you are dedicated.
A final note on TDF is neither a pro nor a con, and that is you need to know if the fund is a "to" or "through" TDF. This means that a fund will rebalance up to the target date and then remain static for the duration of your ownership. A through fund will continue to rebalance after the target date and, in many instances, well past the age of 65 until it reaches its terminal allocation; for more information on TDFs, visit Target Date Funds.
If you have any questions or need any assistance, contact me directly if you are in or near the Metro-Nashville area. If you are outside of Tennessee or prefer a non-virtual relationship, seek out a qualified fee-only Registered Financial Consultant near you.