What is a Target-Date Fund? According to investopedia.com target-date funds are mutual funds or exchange-traded funds (ETFs) structured to grow assets in a way that is optimized for a specific time frame. The structuring of these funds addresses an investor’s capital needs at some future date—hence, the name “target date.” Most often, investors will use a target-date fund to apply to their onset of retirement.
Target-Date Funds have grown dramatically over the last few decades. They are intended to be the solution for those that want to abdicate their investment decision responsibility. The plan sponsor also reduces fiduciary responsibility by providing a default option for the employee. The concept sounds reasonable. The typical young investor (30 years old) will have a target date 35 years out. That individual is assumed to have a high-risk tolerance with many years ahead to earn the higher average risk premium in stocks. Such a fund will begin heavily over weighted in stocks and systematically reduce the stock weight over time into bonds and cash. So, what are the problems?
Example 1: Vanguard Target Retirement fund 2025 (VTTVX) invests in four of its own index funds that cover the Total U.S. Stock Market, Total International Stock Market, Total US Bond Market and Total International Bond Market. The expense ratio is 0.15% and the Morningstar ranking is four stars. Morningstar looks into the composition of these sub portfolios and reports the following asset allocation for the entire target fund.
Example 2: The Putnam RetirementReady 2025 A (PRROX) indicates on its website that it holds six of its actively managed funds and its money market fund. The expense ratio is 0.98% and the Morningstar ranking is two stars. Morningstar reports its overall asset allocation as:
While the Putnam website indicates 4.81% in the money market fund, cash held in the other six funds brings the total to 20.98%. Since the fund expense ratio is 0.98% and cash earns near zero at this time, means investors are guaranteed to lose about 1% on 21% of this target fund. There is also substantial managerial risk in the remaining actively managed stock and bond strategies.
Example 3: The PIMCO RealPath 2025 Fund class C (PENWX) indicates on its website that the sub-indexes represent stocks, bonds, TIPs, commodities and real estate securities. The expense ratio is 1.87% and the Morningstar ranking is one star. Morningstar reports its overall asset allocation as:
Note the large % Short and % Long positions in Cash and Bonds. That means a lot of leverage is being employed. Leverage is effectively borrowing money to invest in more assets than the fund has capital. The sum of the long position percentages is 291.06%. That means a $100 million-dollar fund is purchasing the equivalent of $291.06 million in assets with an additional $191.06 million in borrowed funds or the equivalent exposure with derivatives. This fund as well as the other examples above were chosen to have the same nine years to the target retirement date. This is when risk is supposed to be winding down. Although leveraging very low risk assets might seem okay relative to no leverage on a high-risk asset, leverage has a potential large downside in a liquidity crisis (i.e., forced selling to meet margin calls). This happened big time in the Fall of 2008.
Besides the risk of managing the leverage within the fund, you want to know how this leverage affects your overall wealth portfolio’s leverage. Whether the leverage is obtained through direct borrowing or derivatives, it is effectively a short bond position. You need to know the maturity and duration (bond risk measure of its sensitivity to interest rate changes) of the position. Adding up all the long and short positions across all your investments is the only way to measure your total wealth portfolio net exposure. The process of aggregation applies to all the risk dimensions of your wealth portfolio. For example, the overall percentage of cash you hold will be decreased by the short (borrowing) positions and will be increased by the long (buy) positions in the mutual funds or Exchange Traded Funds (ETFs) you own. Similarly, the interest rate sensitivity of your longer-term bond investments is being reduced by your 30-year fixed rate mortgage (borrowing) on your home. Keeping track of all this information seems daunting, but modern technology can do all this for you in the background.
The important point of the three examples above is to show that all target funds are not alike. They each have their own costs and investment risks that are not likely to fit your unique personal goals. The only time I was forced to recommend including a target fund in a family member’s 401K was to allocate 100% of that 401K to the Vanguard Target Retirement 2050 Fund. All other funds available to him in the plan were poor choices (high expense ratios, active management with weak performance and elusive risk exposures). Being young, the cash allocation in Vanguard’s 2050 is small; it’s composed of all index funds and has a low expense ratio without double dipping. Furthermore, it was a small part of his wealth relative to his taxable account where all the remaining or offsetting exposures can be obtained in other accounts. This individual will rollover that 401K to an IRA when next changing jobs and then have complete control to achieve a superior portfolio strategy.
Good News: You don’t need target date funds to achieve a dynamic time dependent risk strategy. You can create your own target date wealth strategy with full knowledge of all the assets you own at a lower cost.
Stanley J. Kon is Chairman of Ripsaw LLC where he oversees research, education, and product development. He also is the editor of the Journal of Fixed Income. Dr. Kon has written extensively in the areas of investment management, performance measurement, asset pricing, statistical models of stock returns and mortgage-backed securities. He has published articles in the Journal of Financial Economics, Journal of Finance, Journal of Business, Journal of Empirical Finance, Journal of Fixed Income and Financial Analysts Journal. He served as the J. B. Fuqua Visiting Professor of Finance at Duke University’s Fuqua School of Business where he taught courses in fixed income securities and risk management. He was also a Visiting Professor at New York University’s Stern School of Business where he received the Executive MBA outstanding teacher award. Prior to that, Stanley was a principal, executive vice-president, director of research and co-director of the investment management group at Smith Breeden Associates, Inc., an institutional investment management company. Prior to that, he was a Professor of Finance at the University of Michigan from 1982-1997. Prior to 1982, Professor Kon served on the faculties of New York University, the University of Chicago and the University of Wisconsin at Madison. Dr. Kon has also served on several bank and holding company boards and as a consultant to government, business and financial institutions. Dr. Kon received his BS in Chemical Engineering from the Lowell Technological Institute, his MBA in Finance and Economics from St. John’s University and his PhD in Finance from the State University of New York at Buffalo.