Investments are constantly adapting to meet investor expectations and desires. The first mutual fund was created in 1924, option trading began in 1973, the 401(k) was established in 1978 and Regulation FD (Fair Disclosure) was implemented in 2000. Since then, many more types of products have been developed ranging from CMOs (Collateralized Mortgage Obligations) to ETFs (Exchange-Traded Funds) to the most recent product – target-date funds.
While mutual funds fulfilled a niche for everyday investors to gain access to Wall Street and analyst knowledge, it’s still been up to the individual investor to know what type of fund to hold and how to balance their own portfolios against risk. But too often investors set up an account and then forget about it, leading to unbalanced portfolios over time. This leads to increased risks and, ultimately, larger-than-expected losses.
In order to cater to a wider audience, a new fund was created – the target-date fund. Originally designed in the early 1990s by Donald Luskin and Larry Tint of Wells Fargo Investment Advisors, these funds didn’t really catch on until 2006 when the Pension Protection Act was passed. This act allowed for auto-enrollment of target-date funds into defined contribution plans and set the stage for QDIAs (Qualified Default Investment Alternatives), which strongly supported the growth of these funds.
Investors have welcomed the new fund type with open arms. Many prefer it over traditional mutual funds because of how target-date funds work. Unlike regular mutual funds, which have a set guideline for investment choices based on the fund type, target-date funds are an all-encompassing product that invests in multiple assets types, including stocks and bonds, all at once. Furthermore, the fund actually changes how assets are allocated between stocks and bonds over time, becoming more conservative as the fund approaches the pre-set retirement date. The maturation date of the fund is displayed prominently with the year following the name of the target-date fund, such as Vanguard’s Target Retirement 2035 Fund.
Arguably, the biggest benefit for investors in target-date funds is that rebalancing becomes unnecessary. As the fund grows over time, the allocation settings between stocks and bonds change along a glide path. Each target-date fund has a different glide-path strategy in mind and may approach a more conservative portfolio quicker than others. Investors should pay careful attention to how a fund’s glide-path strategy could affect their retirement goals.
Follow our dedicated section on Target-Date Funds to learn more about these funds.
The Current State of the Target-Date Fund Industry
In 2017, target-date funds passed $1 trillion in assets under management to $1.11 trillion, bringing to light the tremendous growth these funds have seen over the past decade. In 2008, the industry held just $158 billion in assets. The chart shows exactly how fast growth has been for the target-date fund industry.
Net inflows to target-date funds reached an all-time high of $70 billion in 2017, with an average increase of more than $40 billion per year since 2008. Interestingly, investors seem to be preferring passively managed funds more than actively managed funds. Around 95% of the $70 billion in net inflows for 2017 were in target-date funds that invest primarily in index funds. The following chart reveals how investor preferences have changed over the past few years.
Contrary to what the name might suggest, passive target-date funds still have active management that allocates investments over time and chooses how those assets are diversified. The difference between passive and active is the use of index funds versus mutual funds.
The trend toward passive funds began in 2015 when inflows to passive funds exceeded significantly compared to those going into actively managed funds. As investor needs change, investment companies are offering more alternatives. As of the end of 2017, there were 60 different target-date funds available, but only 41 different fund providers meaning that some companies offer more than one type of target-date fund.
Rise in Popularity Over Low Cost
One of the biggest positive catalysts for target-date funds has been its expense ratios. Over the past several years, the average expense ratio has been on a downward trend falling from 0.91% in 2012 to 0.66% as of 2017.
One of the reasons for the trend is the fact that investors tend to prefer a less expensive alternative wherever its offered. Most fund’s most popular offering is the cheapest in regards to the expense ratio, and passively managed funds that invest in index funds have the lowest fees associated with them. Actively managed funds, while providing a similar service, come with a higher expense ratio and have been largely passed over by investors who are simply seeking the cheapest alternative.
The trend toward lower expense ratios correlated with the growth in passively managed target-date funds. Increased competition between firms has also helped expenses come down, letting investors reap the benefits.
How About Performance?
While investors seem to be leaning toward passively managed funds, active management, albeit with higher fees, does have its advantages. The ability to outperform the index is a strong draw, especially considering that target-date funds haven’t performed that well relative to the S&P 500.
Take a look at how target-date funds have performed over the past five years compared to the S&P 500:
Target-date funds are clearly underwhelming in terms of performance. But the reason is simple: they’re designed to supplant the need to re-balance portfolios. Target-date funds aren’t built to act as a one-stop retirement funding solution, they’re simply a tool to help investors mitigate risk over time.
Target-date funds are quickly becoming the retirement asset of choice for investors, and with more firms offering more than one type of target-date fund, they could pose a risk to standard mutual fund offerings in a defined benefit package. As their popularity grows, investment companies may cater more to the everyday investor and those who are used to keeping a hand on the wheel of their own portfolio could start seeing their options reduced.
Worried about the potential risks associated with these funds? Click here to learn more about how to conduct due diligence for these funds.
Find out about the most important criteria for selecting a mutual fund here.
The Bottom Line
Long gone are the days of investors needing to keep their own portfolios balanced on a regular basis. Target-date funds give investors the option of a true “set it and forget it” style of investing. It takes the legwork out of managing a retirement portfolio and allows investors to take advantage of professional management for a fraction of the cost. Although target-date funds currently lag the indexes performance-wise, the proliferation of these types of funds means they are likely here to stay.
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