What Is an Index-Based Target-Date Fund?

It’s easy to see why investors continue to plow some big bucks into target-date funds in their retirement accounts. The fund type features a unique “glide path” that the portfolio follows to become more conservative as it moves towards its end date, usually when the investor is set to retire. By using a target-date fund, investors get instant asset allocation across stocks, bonds, cash and for some funds, even alternatives.

But there is a problem with all that diversification. Namely, most target funds are chock full of actively managed mutual funds. Typically, actively managed funds underperform the markets as a variety of factors eat away their returns. Over time, especially for investors with decades to spare, that difference can make or break a retirement portfolio.

There is a solution, however: index your way to a better retirement.

There is now a whole host of index-based target-date funds on the market. And they could be an investor’s best friend.

The Best of Both Worlds

Perhaps the biggest criticism of target-date funds is that while they provide plenty of diversification, those benefits are meaningless if the underlying mutual fund holdings are junk. That’s because most target-date funds use actively managed portfolios. And while there are some managers that often continue to beat the market, the vast bulk of them underperform in a big way. According to recent and historical data surveys from Dow Jones S&P Indices, 88.65% of large-cap managers could not match the performance of the benchmark S&P 500. Small- and mid-cap numbers were a tad better, but the difference was still staggering, and it was the same for international stocks.

The culprit for the benchmark miss was a combination of higher fees paid on actively managed funds and sheer human error. This is why many investors have been flocking to low-cost index funds, or those that track a specific stock or bond market benchmark.

Now, many target-date funds sponsors are offering TDFs that use only index funds as their holdings.

By using only index funds, these TDFs get the asset allocation right as well as reduce the chance for underperformance. An index fund will always return slightly less than its benchmark because there are still some fees associated with the fund. However, some index funds have expensive ratios of around 0.05%, or just $5 per every $10,000 invested. The difference is negligible. Additionally, the overall fee structure for index-based target-date funds is usually significantly less than their active rivals.

Some Considerations for Index Target-Date Funds

With index funds being the better choice for most investors, they aren’t perfect either. Perhaps even more so in a target-date vehicle. For starters, the particular indexes used can be a huge issue when it comes to returns. The S&P 500 is considered the large-cap proxy, but it’s not the only one. The Russell 1000, Dow Jones Wilshire Large-Cap Index, and CRSP US Mega Cap Index are all popular indexes that have billions of invested dollars in them. Each holds a different series of stocks and each has performed slightly differently over time. The same can be said across market-caps, styles and nations.

If your target-date sponsor picks the wrong horse, you could miss out.

You could also miss out if your sponsor does happen to have a few of the active managers that actually outperform their benchmarks. The ones who do manage to beat their benchmarks often do so by an average of 1.2% a year after fees. Compounded that’s a lot of return left on the table. And let’s not forget that index funds can’t save during market crashes the way an active manager can move to cash at the first sign of panic.

Finally, an index target-date fund could still become an overcomplicated mess, even though it’s designed for simplicity. Some TDFs will include an index fund tracking large-cap blend, large-cap value, large-cap growth, etc., and at the end of the day, investors are left with 16-plus funds. That many funds defeats the purpose of cost-saving indexing in the first place.

The Bottom Line

Target-date funds remain a great choice for retirement savers, but their downside has been their reliance on active management. Today, there is a new breed of target-date funds that use index investments to overcome the underperformances and high costs. For investors, they could be a portfolio’s best friend.

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