With over 7,000 different mutual fund options available to the investing public, selecting the correct choice can be tricky. Target-date funds are designed to help manage investment risk in a single diversified mutual fund.
These funds are designed to work around your designated retirement year or “target date.” Target-risk funds are investments designed to match a certain risk tolerance of the investor through a specific asset allocation strategy.
In this article, we’ll discuss the differences between a target-date fund and a target-risk fund, and which can be a better investment choice depending on your specific financial goals.
Typical Characteristics of Target-Date Funds
Target-date funds work by rebalancing the asset allocation throughout the fund’s life until it hits the target date. As the fund nears the target date, it gradually gets more conservative, shifting from a larger allocation in stocks and into bonds and cash. This movement is called the fund’s glide path. So, for example, a target-date fund purchased today will be considerably more aggressive with a higher concentration than in 30 years, when it will have automatically shifted into bonds and cash. You can read how target-date funds work to familiarize with this class of mutual funds.
However, not all target-date funds are created equal. Each investment company has a different investment style and risk tolerance to its glide path. Some target-date funds incorporate a passive investment approach, like the Vanguard Target Retirement 2055 Fund (VFFVX). In return for the index-fund approach, the target-date fund has a very low expense ratio of 0.16%. Alternatively, some managers use an active management approach. For instance, the Fidelity Freedom 2055 Fund (FDEEX) offers more diversification among many more specific asset classes, like real estate, emerging markets, mid cap, small cap, high income and floating rate. However, the fund is considerably more expensive with an internal cost of 0.77%.
In addition, target-date funds have varying risk tolerances between different fund managers, who can have different asset allocation policies. In this context, you might want to check the pros and cons of target-date funds.
Areas of Differences with Target-Risk Funds
Target-risk funds are similar to target-date funds because they give investors a simplistic way to invest in a diversified portfolio. Both target-risk and target-date funds consist of an asset allocation policy that is set according to the fund’s investment strategy.
However, unlike the target-date fund in which the asset allocation changes to become more conservative over time, a target-risk fund is designed to stay consistent with the investor’s risk tolerance.
- For example, the Sun Life Financial Granite Aggressive fund is designed for investors who have a high level of risk tolerance for long-term aggressive growth. This is pretty obvious from the investment breakdown that shows the fund is invested in 80% stocks and 20% bonds. On the opposite end of the risk spectrum is the Sun Life Financial Granite Conservative fund that is invested in 63% bonds, 27% stock and 10% in cash. This target-risk fund is considerably less risky than the aggressive growth counterpart and is intended for investors with very little tolerance to risk.
It is interesting to note the real point of difference between target-date funds and Target-risk funds – i.e. their core investment philosophy. While target-date funds rebalance in order to achieve a specific return geared toward the investor’s retirement goal, target-risk funds rebalance in order to maintain a constant risk profile for the investor that is initially agreed upon at the time of investment.
Key Factors to Determine the Choice of Investment
Determining whether a target-date fund or a target-risk fund is better for you is dependent on a variety of factors. Both funds are considered “one size fits all” and offer automatic rebalancing as part of the investment strategy. Both are also diversified, depending on the asset allocation strategy and risk tolerance levels you are looking for. From a fee perspective, both target-date funds and target-risk funds are relatively close in expenses, especially for fund houses like Vanguard that specializes in low-cost index-based funds.
Apart from the similarities mentioned above, target-date funds and target-risk funds are quite different in terms of the way they operate during the tenure of the investment period.
The primary difference revolves around the triggers that initiate the rebalancing activity once the investor commits to a target-date fund. These funds constantly churn assets and the risk tolerance levels, depending on your objectives. The earlier you buy a target-date fund, the more aggressive the fund is. For instance, the Vanguard Target Retirement 2055 Fund is nearly invested in 90% stocks now but as the fund gets closer to its target date, the fund will gradually reduce its risk level.
Another point to note is that these funds are blind to the market conditions and are only designed to follow a predefined glide path that specifically adheres to your long-term financial goals. For instance, in a bearish stock market, a target-date fund would not change its overall allocation to equities.
A target-risk fund does not change according to age but according to market conditions, in order to maintain the risk tolerance level assigned to the fund.
For example, the Sun Life Financial Granite Conservative fund that is invested in 63% bonds may convert some of the allocation to cash if the fund manager believes that there are negative signs in the bond market. The same fund, if managed by a more aggressive manager, may allocate a larger portion into stocks, or other specific sub-classes within stocks like international, emerging markets or mid and small cap. This dramatic range of asset allocation strategy changes is one of the reasons why target -isk funds might be more appealing to investors with greater risk appetite.
So depending on your financial goals, availability of financial resources and risk tolerance level over the course of the investment period, you can choose either type of fund.
Strike a Balance Between Investment Goals and Risk Tolerance
It’s quite evident that target-date funds are better for investors who have a higher risk tolerance during their middle ages. Meanwhile, target-risk funds tend to ignore long-term goals and primarily focus on maintaining a specific portfolio risk tolerance level. Therefore, it all boils down to one important factor – how you would prioritize your investment goals vis-a-vis your risk tolerance level in the long run.
Let’s consider these scenarios to better understand this dilemma:
- Having a low risk tolerance over the long term may cause your investment to vastly underperform, thus failing to achieve your investment goal. If this is your case, you should either increase your risk tolerance or reduce investment goal, i.e. accept lower retirement income or retire early.
- Conversely, if you are a retiree with an aggressive portfolio you may be exposed to an unnecessarily level of risk. In this case, you can ensure your retirement objectives even if you shift to a conservative portfolio.
The Bottom Line
In most cases, the simple and hassle-free asset allocation process and diversification benefits of target-date funds can better match your financial goals at or after retirement than that of target-risk fund over the long run. In the end, you must walk the tightrope of balancing your risk tolerance level with your investment goals.
Be sure to follow our Target-Date Funds section to make the right investment decision.