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Taking Aim at Target Funds

In today’s market, it seems that target-date funds and other lifecycle funds have a bull’s eye on them. Many financial commentators have taken aim at these investments claiming that they have failed investors. I think it’s the critics who have missed the mark.

Target-date funds, which fall under the general category of ‘Lifecycle’ funds, are one of the great innovations in financial products for average investors. They are also called ‘funds of funds’ or ‘all-in-one’ funds, because they usually contain several types of funds within one mutual fund or exchange- traded fund. They provide a self-contained portfolio, so that an investor gets convenient broad-based diversification and professional management with a low minimum investment. Typically, they encompass large and small company U. S. stocks, foreign stocks, and various types of bonds. Some even offer real estate and commodities for further diversification.

The target-date retirement funds are the most popular all-in-one fund because they are found in may 401(k) plans. They are designed to provide an investor with an allocation appropriate for someone with an expected retirement around the time of the stated date. For example, the Vanguard Target Retirement 2020 Fund is geared for people expecting to retire around the year 2020. The target dates usually come in five-year increments. The mix of investments within each portfolio tends to emphasize growth before the target date, but they become progressively more conservative as the goal year gets closer. During the retirement years, the risk profile will shift even more rapidly to reflect the greater need to preserve assets rather than to grow capital.

The shifting of the allocation within these funds over time is referred to as the 'glide path'. This glide path has been the source of the most criticism. Critics claim that investors close to retirement suffered too great of a hit with many of these funds over the last two years. They certainly took a beating during the market meltdown – but this does not mean that the concept is flawed. During the financial crisis, virtually every investment with an element of risk incurred losses. Even so, diversified portfolios held up pretty well all things considered.

The Vanguard Target Retirement 2010 Fund had a loss of 20.7% in 2008. This might seem like an unacceptable outcome for someone near retirement age, but also note that it gained 19.3% in 2009. For an investor in the fund for the last three years – which covers the worst financial period since the Great Depression - the cumulative return was positive 1.3%. Although this return is nothing to write home about, I would say that the fund did its job considering the extreme events during this period.

At the time of the market crash, the Vanguard 2010 Fund was about 55% in stock funds and 45% in bond funds. When the stock market as a whole was down over 50% from peak to trough, the allocation to bonds cushioned the loss with U.S government bonds comprising the bulk of the income side of the portfolio. Currently the fund is about one-half in stock funds and one-half in bond funds, which is a reasonable allocation for someone assumed to retire this year and those who should plan to live another 30 years or more in retirement.

Of course, some target funds did worse than others, and some I would never recommend due to high expenses and/or commissions. However, companies like Vanguard and T. Rowe Price have made lifecycle funds an excellent choice for investors who want an all inclusive option.

These funds are particularly well suited for 401(k) plans and Roth IRAs, where you will be adding to the account on a regular basis. Investors with relatively small accounts should also consider this type of investment, because you would receive virtually all the benefits of a customized portfolio but with much less time and effort to manage it. The funds do all the work for you to allocate and rebalance the assets. Once you choose the fund, there aren’t many other decisions.

There are other types of funds-of-funds besides target retirement funds. Some lifecycle funds are based on a risk profile and/or stage in life, such as Aggressive Growth, Conservative Growth or Retirement Income. In addition, 529 college education savings plans operate in a similar manner. They offer age-based accounts so that the portfolio is designed according to the age of the child. An account for a newborn might start with 90% or more in equities, but progressively reduce the stock exposure as the child nears college age. By the time a child reaches college age the allocation might be less than 15% in stocks with the balance in bonds and money market accounts. This is the approach I usually recommend for 529 accounts, as it makes perfect sense if you think about it. You don’t want to suffer a major loss, just as your child enters college.

When compared to college money, retirement money will be needed over a much longer timeframe. Retirees often forget that they won’t need all their money ‘day one’ of retirement – they might just need a little each year for supplemental income. Since we all have different needs and circumstances, the target date of the fund does not tell the whole story. When selecting a lifecycle fund, you should base your decision on the allocation and characteristics of the fund rather than the name.

For example, a fund called Moderate Growth might be too aggressive for many investors. Just because you choose a target 2030 fund, it doesn’t mean you have to retire in 2030! You have to look deeper into the fund to find the mix between stocks and bonds as well as the types of funds within them. I prefer index funds, which makes Vanguard an excellent choice. I also like the fact that Vanguard increases the exposure to inflation-protected government bonds as the equity exposure is reduced over time, thereby continuing to provide an inflation hedge.

Mutual funds have minimum investment amounts to consider. For instance, you would need $3,000 to get started with Vanguard. This might be too much for a young person just starting to invest, so a good alternative might be the iShares Target Date series of exchange-traded funds. As an ETF, the iShares products can be purchased from any discount broker for a very small initial fee.

Lifecycle funds have also drawn the attention of regulators. There will undoubtedly be new legislation enacted to oversee these funds over the next few years. I’m certain there will be a lot of discussion about consumer protection, as well as the appropriate glide path for retirees. I would definitely welcome more consumer education and greater disclosure requirements, so that investors don’t experience any unpleasant surprises. However, if regulators want to really help investors, they should set their sites on lowering fees and encouraging greater use of target-date and other lifecycle funds. That way, you can keep your investment strategies on target in 2010 and beyond.