Target-date asset-allocation funds are designed to be held until a specific year in the future -- the year you intend to retire. Initially, the funds hold an aggressive mix of stocks and bonds, but they gradually become more conservative as the target date approaches. The funds' holdings are rebalanced automatically, and ideally, investors get a portfolio they won't need to think about until retirement.
Target funds are essentially funds of funds, investing in a portfolio of other mutual funds. They start out with more stocks than bonds in their portfolios, and over time reverse this, ultimately focusing on creating cash dividends instead of growing the principal. Planning to retire in 2030? Buy a fund with a 2030 target date, and as that time frame approaches, your fund will unload stocks and add more income-generating bonds.
Target funds have been in the spotlight recently because of the pension reform bill passed in August of 2006. The new rules permit companies to automatically defer employee earnings into 401(k) accounts unless the worker opts out. Target funds might be the fund choice for many companies, since they are designed as a one-decision fund.
Make life easy
According to investment theory, the longer you have before you cash in your investment, the more risk you can take. This lets you invest a larger percentage of your portfolio in stocks, which is why target funds hold more equities when they have a longer time frame.
Investment theory also says that the greater the risk, the greater potential for return. If you're investing for more than 10 years, stocks will generally provide higher returns than less risky assets such as bonds; therefore, your stock holdings should be higher when you are younger and lowered as you near retirement. Target funds make these adjustments between stocks and bonds automatically, saving you the time and trouble.
Performance and fees
When selecting a target fund, it's important to get the best possible performance at the lowest fee level. Most target funds invest solely in other funds offered by the same fund company, thereby limiting the options for finding a high-return fund. You should look for a fund company that includes enough good funds to create a solidly performing target fund. You might also want to discover how well each fund's holdings perform individually.
Because they're funds of funds, target funds' expense ratios usually have two components: the fees of the underlying funds, and fees for overseeing the aggregate portfolio. Target funds are designed to be held for long periods of time -- 30 or even 50 years. In that time, high fees can erode returns. With a return of 10%, a fund with an expense ratio of 2% would give you a real return of only 8%. That same 10% return on a fund with a 1% expense ratio would translate into a total return of 9% instead. That slight difference adds up over time, and it can be the difference between a good retirement and an uncomfortable one.
For diversification and potential returns, it's important that the funds held by a target fund include a variety of asset classes. Consider categories such as emerging markets, international stocks, and small-cap stocks. On the other hand, too much diversification may mean that the fund duplicates the returns from the overall market.
Many target funds have relatively low exposure to international funds, while some don't put enough of their assets into small-cap and value stocks. Other funds have too much money in cash, weighing down their performance.
Since target funds are not individually crafted, the fund nearest to your planned retirement date might be five or so years off, making it difficult to match your time frame with an appropriate fund.
Target funds can help you meet your financial goals, but you should also consider how the fund fits with your current holdings before making a purchase.
Target funds come from a number of fund families, including Barclays LifePath Funds, Fidelity Freedom funds, T. Rowe Price Retirement funds, and Vanguard Target Retirement funds.
Ideally, a target fund should include funds with relatively low expense ratios, run by top-performing managers. Vanguard and T. Rowe Price are two fund families with low costs and solid underlying fund performance.
T. Rowe Price Retirement 2030
Vanguard Target Retirement 2035
Do it yourself
If you want to actively manage your portfolio, or specifically match your retirement date, you could create your own asset-allocation target fund from a single fund family, or select some of the best funds available from a variety of shops. Of course, you'll also have to perform the periodic rebalancing.
Alternatively, you could purchase shares in a total stock market index and a total bond market index fund. Once again, you are responsible for rebalancing annually. You could even sprinkle in some international stock and bond index funds for more diversification. This is essentially the same thing that the Vanguard fund above does, but doing it yourself gives you greater flexibility to match your unique goals and objectives. Since you're not selecting actively managed funds, don't expect to beat the market -- but then again, most actively managed funds can't accomplish that feat, either.
Target a top-notch retirement
As you plan for retirement, a target fund might be worth considering. Make sure that the fund you select matches your risk tolerance and your personal retirement goals. For such a crucial part of your life, owning two target funds instead of one might be a Foolish move.
Further fund-tastic Foolishness:
Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds mentioned in this article. The Motley Fool's disclosure policy is always on target.