Under the SMART framework, well-defined investment goals are time-bound. This concept defines when we'll need to use the money from our investments to pay for these goals. Professional investment managers used this concept to create target-date funds.
We often use target-date funds as a simple investment vehicle for long-term investment goals like retirement or saving for a child's college education.
How they work
Target-date fund managers name these funds by the year the investor will need cash, so they will use the time horizon to create a portfolio and consider the risks on our behalf.
For example, Vanguard, a popular investment manager, launched Vanguard Target Retirement 2065 funds. These funds are for anyone planning to retire in 2065 and give the portfolio managers a timeline for growing the investments. In 2065, the fund doesn't dissolve; instead, the portfolio manager implements a reasonably safe strategy and stops actively managing the fund.
Longer time horizons allow us to take more risk, but the investments in target-date funds change over time.
Following the initial launch, a target-date fund starts with an aggressive portfolio, invested mainly in stocks. The fund manager tries to maximize returns early on since there's enough time to make up for any downturns. As the fund approaches the target date, the fund manager adjusts the portfolio to be more conservative. They want to lower risk by investing more in bonds and holding cash.
Every year, the portfolio managers reassess and reset the allocation of investment categories to decrease the risk slowly. Many managers call this a glide path and will visualize the changes in risk over time.
Target-date funds provide several benefits:
- One-stop-shop: Instead of requiring multiple investments, a single target-date fund can help us achieve our investment goal for retirement.
- Diversification: Most targeted-date funds are funds-of-funds. The portfolio manager of the target-date fund will pick individual stocks, other mutual funds, or ETFs to implement their investment strategy. By having a basket of other funds, we've diversified with our single investment.
- Professionally managed: We don't need much experience with investing to benefit from targeted-date funds.
As convenient as target-date funds are, there are tradeoffs:
- Lack of control: We don't control where our money is going. If we are socially conscious investors, we can't tell the portfolio manager where not to invest.
- High fees: A funds-of-funds strategy can be more expensive. Portfolio managers of a target-date fund charge a fee in addition to other expenses for any investments in the target-date fund.
Picking a target-date fund
Selecting a target-date fund can be very straightforward, with a few criteria to consider:
Most people retire at age 65.
We should pick a target-date fund that matches the year we turn 65 or coincides with our retirement goal. While that's the most popular way of selecting a target date, we can skew towards more or less risk. If we want lower risk, we can pick a Target Retirement 2055 fund even if we turn 65 in 2065, or go with a Target Retirement 2070 fund to take more risk.
A lower expense ratio means paying less in fees. Expense ratios differ between target-date funds based on the manager and strategy. Actively managed target funds are more expensive than passively managed funds or ETF-based target funds.
The investment performance will tell us if the portfolio manager is worth the fee. Some target-date funds have been around for less than 10 years; however, we can sense the portfolio manager's performance if the average 5-year return is available.
In the example of both Fidelity 2060 funds above, the average 5-year return of FDKVX is higher, tempting us to think it's a better choice. However, it charges six times more in fees. When subtracting out the expense ratio, the returns are comparable.
The expense ratios are fixed every year, regardless of the returns. Higher fees don't guarantee higher returns and can even cause our actual returns to be worse than lower-fee funds.
Target-date funds are beginner-friendly financial products that provide the benefit of a managed account without paying the higher fees charged for custom investment advice. The funds are flexible and useful for goals with different time horizons.
For example, you might have a few different goals and not much time to manage your investments. You can choose a few target dates that match your goals, investing money every month into those funds.
If you have a 401(k), you probably have access to target-date funds. However, the funds and managers available might be limited depending on the 401(k) administrator and provider. You can do a 401(k) to IRA rollover when you change jobs or open a brokerage account for more choices of fund managers at Fidelity, T Rowe Price, or Vanguard.