The crux of target-date funds is to make investing as simple as possible by gradually adjusting to a more conservative investment mix as a target date approaches. In the U.S., target-date strategies often serve as the default investment option in many Americans’ defined-contribution retirement plans.
Jeff Holt, Director of Multi-Asset and Alternative Strategies at Morningstar Research Services LLC, notes that the persistent growth and massive amount of assets ($1.7 trillion at year-end 2018 in target-date mutual funds and target-date collective investment trusts) mean that target-date strategies are playing a key role in helping meet the retirement goals of more and more investors.
The popularity is driven by low expense ratios, and those that hold mostly index funds appear poised to take the lead with Vanguard dominating the market. You can read more here.
Josh Charlson, Director of Manager Selection at Morningstar Research Services LLC, has been impressed by target-date funds and how they have managed to roll up a highly sophisticated investment process into a product that’s extremely easy to use for the average investor.
Here he distills what he thinks are some of the most effective aspects of target-date products and suggest ways that those of us who manage our own portfolios might adapt those techniques to our own investment practices. While he admits that the list is by no means comprehensive, it highlights some of the most important and tangible lessons investors can take away from target-date funds.
Lesson 1: Invest with your goals in mind
This point may seem obvious, but the reality is that most of us accumulate investments in a haphazard manner, without much of a bigger-picture viewpoint on how our allocations should look from the 3,000-foot level.
Target-date fund managers flip that equation on its head: They begin by asking the biggest and thorniest questions --in order to generate the asset allocations used across the various vintages of a target-date series (what’s called, in industry parlance, a glide path):
- What percentage of people’s working income will they need to generate from a nest egg in retirement?
- How long will it need to last?
- How best should they invest that money during their working years to get to that point?
Certain perspectives will inevitably get baked into these processes, accounting for the different glide paths among target-date providers; one provider may believe it’s more important to emphasize safety of capital near an investor’s retirement date, for example, while another may believe growing the nest egg retains higher importance at that point.
As an individual investor, you have an advantage over target-date funds. While they must create allocations that will potentially work for hundreds of thousands or millions of participants, you have an investor base of one. You know your financial situation and future prospects, your comfort with risk, and the specific financial goals for which you need to save. This doesn’t mean you have to get things 100% accurate; there’s as much art as science to asset allocation. But if you start by asking the right questions of your financial goals, risk capacity, and so on, you’ll get your portfolio a large part of the way there.
Lesson 2: Invest in equities early and often
This comes as something of a corollary to lesson No. 1. Most target-date managers have reached the conclusion that the best way to help their investors overcome the retirement-savings challenge is to allocate heavily to stocks when they are young. The average target-date series holds 90% in stocks in their longest-date funds (those intended for investors just starting out in the workplace), with some investing up to 100%. Even funds intended for investors 15 years away from retirement tend to tilt heavily toward equities: The industry average is 72% in stocks, while firms with equity-heavy glide paths like T. Rowe Price invest as much as 80% in stocks.
This makes perfect sense, as equities offer meaningfully higher long-term return prospects than bonds, and though they can suffer pronounced drawdowns, the long time horizon of most target-date investors means they should be able to ride out the dips.
Self-directed investors should adopt a similar mindset. Once you’ve gone through the exercise of developing an asset-allocation perspective, try to maximize your exposure to equities (within the constraints of your risk tolerance, risk capacity, goals, and needs, of course). This holds doubly true if you are more than 20 years from retirement. The road may be bumpy at times, though, and investors who may need to draw on their nest egg nearer-term should keep in mind that we have witnessed a historic run for the stock market over the past decade, one that is not likely to be repeated.
Lesson 3: Adjust your allocation over time
One of the niftier aspects of target-date funds is that they take over many of the laborious and technically challenging tasks associated with portfolio management. Two in particular are rebalancing and rolling down the glide path. Rebalancing is important because over time, as one sub-asset class does well while another lags, your initial allocations will become skewed. Target-date funds typically rebalance to their target weights on a monthly basis, if not more frequently, relying on both inflows from new investors and sophisticated trading technologies to ease the process.
For investors who have a lot of funds, this can be a challenging exercise, so it’s probably best to limit the review to once a year, and to set relatively generous thresholds for when you will restore allocations to their target levels (perhaps when they hit a 10% deviation or more).
Target-date funds also engage in an annual “rolldown” of the glide path, by which they incrementally shift the stock/bond balance in the portfolios so that investors move toward the appropriate allocation for their ages. For DIY investors, there would be little advantage (and probably some disadvantage ) to make such a small shift on an annual basis. Still, it’s important to recognize that one’s appropriate asset allocation will differ from age 20 to 50, from 50 to 70, and so on, so at least every few years we should evaluate whether that initial allocation plan still makes sense, or whether it’s time to shift a chunk from stocks to bonds.
Lesson 4: Diversify
Yes, diversification has been a tough sell in recent years with the equity market on a roll. But target-date managers don’t back off from diversification, and neither should you. Indeed, one of the biggest selling points of target-date funds is their ready access to multiple asset classes: domestic equity, international bonds, emerging-market equities, real estate, high-yield bonds, and often more specialized asset classes. The average 2060 target-date fund has around 30% of its equity sleeve in non-U.S. stocks. And while diversification can often feel painful in the short term, its long-term benefits are clear in both theory and practice.
Lesson 5: Stay the course
This last point gets at what may be the biggest benefit of target-date funds: their positive behavioral impact on investors.
We can best view this from the funds’ positive gap between their investor returns and total returns over 10-year periods. Most fund categories evince a negative gap, reflecting the poor timing exhibited by investors when they buy and sell funds. Target-date funds produce on average higher investor returns than total returns. Most investors buy in through 401(k) retirement plans with automated savings processes, which creates a disciplined track of continued savings. You could argue that some of this may be simple inertia (which may not be a bad thing), but much of it is inherent to the design of target-date funds. Even in 2008, there was minimal movement by investors to withdraw assets from target-dates.
We’d all do well to model the behavior that target-date funds have instilled in investors. Establishing a diversified investment plan and sticking with it, making regular contributions, and paying as little heed as possible to the noise of the markets around us, is likely to be a winning formula, whether we invest directly in a target-date fund or adopt its principles to our own portfolios.
A version of this article appeared on Morningstar.com
