There are few guarantees in the world of investing, but one thing is certain: Where there's demand for investments, Wall Street will happily provide the supply. And right now, demand is high for target-date funds -- asset-allocation funds that are designated by the year in which an investor plans to retire. More and more firms are launching versions of these funds, as the investing public grows more accepting of the idea of life-cycle investing. But before you invest in a target-date fund, there are a few things to keep in mind.
Life-cycle funds typically hold a mix of stocks and bonds, and are designed to be held throughout someone's investing career. Those funds with more distant retirement dates (such as 2030 or 2040) are managed more aggressively than those with closer retirement dates (such as 2010). The longer-range funds will hold a higher equity allocation, gradually reducing that exposure over time as the target date approaches. Because no ongoing adjustments need to be made by the investor, these funds are the ultimate in set-it-and-forget-it investing.
More and more retirement plans are now starting to offer some form of target-date fund. While these funds were almost unknown several years ago, now roughly 25% of plan sponsors offer the funds. And once the government finalizes its list of acceptable default investments under the recently passed Pension Protection Act, life-cycle funds will likely get an additional boost, since they'll almost certainly make the final cut.
This means that a lot more retirement money will be seeking out target-date funds. And investment firms can see the dollar signs already. According to Morningstar data, 25 target-date funds have been rolled out so far this year, and firms such as UBS Asset Management, PIMCO, and Nationwide Fund Advisors are planning to launch target funds in the near future. But having more options available means that investors will have to be able to differentiate amongst the various life-cycle families before deciding on an appropriate fund.
One of the first things you should know about a target-date fund is whether it uses a fund-of-funds approach or invests in unique holdings. For example, the Fidelity Freedom family of funds employs a fund-of-funds method. The Fidelity Freedom 2040 Fund
On the other hand, the Alliance Bernstein series of funds invests directly in equity and bond securities. So the Alliance Bernstein 2040 Retirement Strategy Fund
What to look for
While a fund-of-funds approach seems like an easy, low-fuss way to invest, a lot of your holdings can overlap if you own multiple funds from the same family. After all, if one of Fidelity's equity funds owns a sizable position in a particular growth stock, it's likely that some of its other funds do so, too. Investors may end up duplicating the efforts of several portfolio managers, owning more of a particular stock or sector than they might prefer.
Target-date fund investors should also know whether their fund manager makes ongoing active adjustments to the fund's asset allocation, or whether the fund's stock/bond mix is more static. For example, does the fund's allocation remain at a roughly 60% equity-40% bond mix, or does the manager have flexibility to move with a certain range, such as 50%-70% equities and 30%-50% fixed income? Consider a fund family that does the latter; odds are that your manager can add value by shifting into more attractively valued asset classes as market conditions change.
Whichever type of target-date fund you decide is right for you, make sure that you're choosing a fund, and a fund family, with a significant history of life-cycle investing. Many of these funds are relatively new and lack any kind of track record. Of the 249 available life-cycle funds in the Morningstar database, only 61 have been around for more than five years. Careful due diligence will help ensure that you choose the correct target-date fund, and that your investment path to retirement is a smooth one.
Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. Pfizer is an Inside Value recommendation. The Fool's disclosure policy is always right on target.