As target-date funds become more and more popular in both retirement plans and individual portfolios, it becomes increasingly important to distinguish the good from the bad. The traditional method of assessing performance is to measure the fund against a predetermined benchmark.

That presents its own set of issues as the target-date fund and its benchmark may not be in alignment with each other. In this article, we’ll take a look at why it’s important to use the right benchmark in assessing target-date fund performance.

In case if you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.

Establishing a proper benchmark for target-date funds is an especially tricky task. Because target-date funds are so unique in that asset allocations, risk levels and glide paths can be significantly different even among funds that share the same target date, there is no one-size-fits-all solution to measuring fund performance. That can give the impression that funds are over- or underperforming when they’re actually not.

Benchmarks should serve a number of important functions:

• Gauging relative performance on a risk-adjusted basis – You wouldn’t want to measure the performance of a bond fund against a stock, nor would you want to measure a large-cap fund against a small-cap one. A good benchmark will help determine what type of return should have been expected for a given level of risk and if the target-date fund was able to outperform that risk-adjusted return.
• Helping to address lack of historical data – The emergence of target-date funds is a relatively recent phenomenon. As such, most target-date funds don’t have more than a 10-year history. A proper benchmark can help establish how an investment strategy could be expected to perform in light of a lack of performance data.
• Aiding in understanding of how the fund fits in a broader portfolio – Benchmarks should help determine what the target-date fund’s composition and risk level should look like. If a fund has an improper benchmark, an investor may think his or her portfolio is properly diversified when, in reality, it may have overlapping sector exposures or be too risky.

Check out our “Do Mutual Fund Benchmarks Matter?” article, to know more about why mutual fund benchmarks better.

Traditional benchmarks like the S&P 500 or Russell 1000 may work fine for actively managed large-cap stock funds, but they’ll likely fail to do the job for target-date funds. Target-date funds are fluid investments that, in most cases, make investments in several regions, sectors and asset classes that change in composition over time. The use of a static single asset class index as a benchmark doesn’t reflect how the target-date fund is invested and likely misrepresents the risk level of the fund. The BlackRock LifePath Index 2020 Fund (LIQAX), for example, has a roughly 50-50 stock/bond investment mix. This fund will likely fail to match the returns of the all-stock S&P 500 over time and potentially give the impression that it’s an underperformer.

A similar problem exists when measuring against a peer group using the same target year. BlackRock determined that a 50-50 asset allocation is appropriate for a 2020 target date, but a target-date fund’s investment strategy is determined entirely by the provider. For example, the Wells Fargo Dow Jones Target 2020 Fund (WFLPX) has only 30% invested in equities. The Fidelity Freedom 2020 Fund (FFFDX) has 65% invested in stocks. Just because funds share a target date doesn’t mean they look anything like each other.

Custom benchmarks can help address these issues to a degree but don’t necessarily solve the entire problem. Many are essentially built to reflect the target-date fund itself so they may undermine the ability of the fund manager to outperform. Custom benchmarks can also change over time. This was the case with the BlackRock fund that recently increased the equity exposure of the portfolio across the entire glide path.

Check out our “Due Diligence for a Target-Date Fund” article, to learn about what criteria to use when choosing between target-date funds.

Several of the big investment data providers, such as Dow Jones, S&P and Morningstar, have created their own sets of target-date fund benchmarks in order to try to establish some common ground in measuring target-date fund performance. Examples include the S&P Target Date series of indices, which include target dates all the way out to 2060, and the Morningstar Lifetime indices, which combine both target dates and risk preferences.

These benchmarks are a step in the right direction but still have their challenges when it comes to measuring funds with similar target dates but very different portfolios.

So what factors should be considered when selecting a benchmark?

• Glide path – Look at the methodology for how the glide path is constructed and see if it is in line with appropriate risk targets. The target date 2020 funds listed above show how different the funds can look.
• Weighting methodology – How is the benchmark constructed? The Dow Jones indices set a high-level stock/bond/cash allocation and then equal weight within the sub-asset classes. Does this accurately reflect the target-date fund?
• Asset allocation – Look at not only the percentages allocated to stocks and bonds but also factors such as style, sector, quality and geography.
• Tracking error – Tracking error is the enemy of any good benchmark. As tracking error increases, its effectiveness as a good benchmark diminishes.
• ‘To’ vs. ‘Through’ criteria – What does the fund do when it hits its target date? Does it switch to mostly cash or does it maintain its target date allocation indefinitely?

There are a lot of moving parts to consider when assessing the performance of a target date fund. The presence of an appropriate benchmark is one but investors also need to consider management fees and how the fund fits with their personal risk tolerance and goals. The lesson, as always, is to know what you’re investing in and how it performs on a risk-adjusted basis.

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