These No-Brainer Investments Could Fail You

What could be more of a no-brainer than a fund that does all the work for you?

"Lifecycle" or "target-date" funds -- funds that gradually alter your asset allocation as you approach a particular date, typically intended to be the year you retire -- have been touted as the complete no-brainer retirement investing option for over a decade.

There's some truth to that -- as a default option in a retirement plan, they're a great alternative to money market funds for eligible employees who don't bother to enroll or elect investment options in their workplace plans. But given that most of these funds have taken large hits in the last year, clobbering millions of retirement portfolios, it's worth taking another look at their pros and cons. Do they really offer a significant advantage over, say, an index fund? Or a mattress?

The good news, the bad news
First, the good: For someone who doesn't have the time or knowledge to put together a diversified portfolio on their own, they're not a bad option. One trade and you're done.

These funds aren't necessarily slugs, either. The best ones give you a little more performance and a little less volatility than an investment in a single index fund would, and those little bits can add up to quite a lot over 20 or 30 years. And the automatic ratcheting-down of risk as the target date approaches can help ensure that your nest egg doesn't disappear on you just as you're about to need it.

But ...
Not everything about them is roses. Consider:

• Most of the longer-term funds have gotten hammered in recent months, along with the rest of the market, with losses of 40% or more being all too common. And like all active mutual funds, the majority will underperform the market (or an index fund) over time. Generally speaking, you're better off with a portfolio of good funds or stocks instead.
• They can be expensive, sometimes layering fees on top of fees. Many have expense ratios over 1%, which is quite high.
• They're designed around the premise that you'll invest 100% of your nest egg in a single fund. That can be unnerving for some.
• They're often not that diversified in practice.

The last one can be a problem. Take a look at Fidelity Freedom 2030 Fund (FFFEX). This fund, a relatively inexpensive fund that's found in lots of retirement plans, invests in a total of 25 different Fidelity funds. Sounds diverse, doesn't it?

But when you look under the hood, you find that the fund has about 40% of its assets in just five of Fidelity's domestic equity funds. And those funds all seem to be buying the same stocks! Look at the overlapping stocks in each of the funds' most recent lists of top 10 holdings:

This kind of overlap is common in big fund families, where stock analysts focused on specific industries often recommend the same companies to several different managers. But you see the problem it creates for us -- the Freedom Fund is concentrated in several big equity funds, and those funds in turn are concentrated in a small group of huge stocks. It's certainly diversified, but less so than you'd think.

So I should avoid these things?
"Absolutely not!", says Foolish fund guru Amanda Kish. Writing in the new issue of the Fool's Champion Funds newsletter, available online at 4 p.m. EDT today, Amanda argues that the best of these funds are a huge boon for those who don't have the interest or knowledge to build an asset-allocation plan from scratch. I'm inclined to agree.

Of course, as Amanda points out, there are good funds and bad funds in any category, including this one. In a retirement plan you're stuck with what they give you -- most often Fidelity, Vanguard, or T. Rowe Price products, all of which (notwithstanding my poking of Fidelity above) are decent choices in the category.

But if you're working with a broker who is recommending a different line of funds, check the total expense ratio and performance history carefully before you invest -- some are very expensive.

If you'd like to see what else Amanda had to say about lifecycle funds -- and better yet, learn more about building a portfolio of top funds on your own -- check out the new issue of Champion Funds. If you're not a member, help yourself to a 30-day trial -- it's completely free of charge, with no obligation. Click here to get started.