Will the Government Cripple Target Funds?

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We all know that the worst time to cut back on stocks is when they've just crashed. Yet many investors and financial regulators are pressuring fund companies to cut back their stock exposure in some of their funds -- at what could potentially be the exact worst time.

Because of 2008's big stock market drop, everyone has their attention squarely focused on downside risk. Apparently, some investors didn't understand that their target funds retained substantial exposure to stocks, even as they approached the beginning of retirement. And now, the SEC is looking at measures that could limit the flexibility of target funds to set their own allocation percentages, and recently held a hearing to get public opinion on what steps to take.

Fund companies are still gauging how best to respond to that pressure. Charles Schwab (Nasdaq: SCHW) recently announced that it would cut the stock allocation in its 2010 target fund from 55% to 45%. Putnam Investments is reportedly considering similar changes.

Meanwhile, several other fund companies, including Vanguard, Fidelity, and T. Rowe Price (Nasdaq: TROW), are standing pat on their target fund allocations so far. Even though their near-term target funds took considerable losses in 2008, fund company representatives see this as yet another example of how criticism follows performance rather than anticipating it.

Why stocks belong in retiree portfolios
Whether near-retirees should have money in stocks -- as well as how much capital they should allocate to them -- obviously depends on the particular circumstances each person faces. If you have so much money that you have no danger of running out, then conservative options can eliminate the risk of losing principal.

But most people have much more limited financial resources. Given increased longevity, nearly everyone needs to worry about potentially running out of money during retirement. If you're trying to map out a retirement portfolio that's designed to last for 20 years or more, then leaving stocks out of the equation simply doesn't make sense.

Not all stocks are the same
The biggest issue I have with condemning target funds for having overweight equity allocation is that the entire debate makes a ridiculous assumption: that all stocks have the same amount of risk. Although you might assume that a fund that has 55% of its assets invested in stocks is riskier than another fund with a 45% stock allocation, you can't be sure unless you know exactly what stocks each fund owns.

For instance, the Federated Kaufmann Fund (KAUAX) recently had about 19% of its money in cash, with a stock allocation of about 74%. Yet as a mid-cap fund, it owns shares of companies such as Illumina (Nasdaq: ILMN), First Solar (Nasdaq: FSLR), and PotashCorp (NYSE: POT) -- stocks that most people do not consider as ultra-conservative.

In contrast, an index fund such as Vanguard Value Index Fund (VIVAX) keeps its stock allocation close to 100% at all times -- but it has more money invested in blue-chip stocks like ExxonMobil (NYSE: XOM) and Coca-Cola (NYSE: KO). As a result, many would consider the Vanguard fund to be less risky, even with a greater percentage of its assets invested in stocks.

Know what you own
Despite the uproar over target funds, there's nothing secret about the way they invest. If you're not comfortable with the way a particular fund company adjusts your portfolio over time, you have several options:

• Pick another company. Different fund companies use different methods for adjusting asset allocations over time. If you prefer another company's approach, make the switch.
•  Choose another fund. If a target fund doesn't have the right investments for your risk tolerance, consider choosing a fund targeted for a different year. Even if the dates don't match up, that other fund might give you exactly the investment mix you want.
• Do it yourself. With a little research, you can create your own combination of funds to form a custom-made target portfolio -- all you'll have to do is make annual adjustments and you'll be all set.

The controversy over target funds and asset allocation will continue for some time. Yet even though stocks have hurt retirees' portfolios over the past year and a half, investors and regulators are wrong to push fund companies to cut back on stocks right now. If you own a target fund, keep an eye on it to stay aware of any changes -- and take action to keep your stock exposure where you want it.

Learn more about fund investing:

• Could a recovery be right around the corner?
• Why should you bother buying mutual funds at all?
• Can "set it and forget it" investing really work?