Despite WordPress crashing and losing this post halfway through, I have managed to rewrite it from memory. Target date funds have become one of the most popular investment vehicles in the US. Over $1.4 trillion is invested in these funds and they comprise 24% of all 401(k) funds in the US. In my last post, I discussed how new guidance from the Department of Labor (DOL) provided a window for the first time for these types of funds to invest in private equity. This move could provide the opportunity for these funds to start to mimic the return and diversification seen in ultra high net worth investor and endowment portfolios. Diversification and the potential for higher returns are great but what are investors actually getting when they invest in one of these target date funds and why did they become so popular in the last decade?

Default Investing

One reason they became popular was lazy investors. The DOL under the Obama administration provided guidance that plan administrators should have target date funds as the default investment for workers enrolling into retirement plans. Prior to this there was a huge amount of retirement funds sitting in cash and money market funds which were the default investments prior to this guidance. Many people didn’t bother to try and invest their funds, possibly because they were intimidated or because they just didn’t want to take the time to do it. If those workers are young it’s even worse because they were missing out on decades of compounding that could have made saving easier later in life when many people realize they are behind in saving for retirement and try to catch up. This could be one reason why in 2017 the median retirement balance for those aged 55-64 in the US was just $107,000.

The basic idea behind the structure of target date funds is that investors can be more aggressive as they are younger and have time to recover from any stock market losses. As they age, they will be looking to preserve some of those gains so they will allocate more of their portfolio to bonds. This is called the glide path. Bonds provide income and in the past have had a somewhat negative correlation with stock prices. This means they tend to increase in value when stock markets fall along with interest rates. Although since the crisis, bonds seemed to have more correlation with stocks, target date funds still stock to this train of thought with bonds as income generators and anti-cyclical wealth preservers. The rolling from stocks towards bonds and cash as one moves closer to retirement looks like this:

Source: Vanguard

The other important feature to note besides the glide path is that the funds automatically rebalance to achieve their target allocations each year. This means for example that if stocks do well for a 90/10 stocks to bonds split, and at year end the portfolio is 95/5, equities will be sold and bonds purchased to bring the target balance back in line.

This is the same for the equity allocation. The target date funds rest on the theory of maximum diversification. That means the equity portion isn’t trying to achieve the return of a US based index like the S&P 500 but tracks both a US index as well as a global index like the FTSE All-World ex-US Index which tracks the entire stock market outside of the US. If either of these deviates significantly from the target allocation for a particular year it is adjusted. This could mean selling away from a hot stock market to pivot funds towards a losing stock market, which has been the case we will see below.

The Pitfalls of the Target Date Fund

In my research for this post I came across a number of commentators who complained that the target date fund was too “one size fits all” and lacked the “personalization” necessary to really be able to manage an individual’s portfolio. I don’t use that argument here because it sounds to me like a veiled justification from wealth managers for their existence.

In fact, there could be advantages to having the auto adjust feature beyond the ease with which it’s done or not being subject to our own investing biases. Wealth managers have their own biases, many of them want to seek You products they get a commission for or can even be prone to the same “hot stock” or “hot market” mentality we can all fall victim to. The target date funds takes your wealth manager’s as well as your own personal investing biases out of the picture.

There are however, some valid downsides beyond this which I want to summarize and address here.

Bond Allocation – The whole idea underpinning the glide path is that investors see gains from stocks that they want to gradually lock in as they get closer to retirement. The conventional wisdom is that bonds increase in value as equities fall because this is usually followed by rate cuts which cause bond prices to increase. This make bonds negatively correlated with stock prices. However there has been some evidence since the crisis that bond prices are more correlated with stock prices than in the past.

In addition, with rates at or near zero, parking money at these low rates 20 years before retirement doesn’t make much intuitive sense. Especially if those bonds won’t even match inflation long term, it’s a potentially losing gamble. When the theory underpinning these funds were formed, it likely didn’t take into account a zero or negative rate world for extended periods of time. Add to that the fact that if rates ever rise, bond holders will likely see big losses as bond prices fall with higher rates.

Large Cap – Following the large indexes mean you get exposure to the large cap stocks. Small cap and small cap growth stocks have been shown to outperform over time but you need to actively attempt to take exposure to these sectors to capture that return. These major indexes in the US are more exposed to those big household names: Microsoft and Apple in the US and Alibaba and Nestle outside the US. Young people especially can benefit from exposure over the long term to small caps.

In my own portfolio, although I have target date funds as my core funds for retirement, I hold more aggressive small cap funds in my other accounts to compensate for the large cap exposure.

International – In a word, international returns have sucked for the past 10 years. In my own Vanguard 2045 fund, almost 36% is allocated towards the Vanguard Total International Stock Index Fund which tracks the FTSE Global ex-US Index, essentially all the stocks outside the US globally. This index has been trounced by the S&P 500 not to mention the Nasdaq over the past 10 years. The index only returned about 4.5% annually for the last decade while the Vanguard Total Stock Market Index, covering all the trades stocks on the NYSE returned over 13.5%. This is a 9% difference over 10 years, enough to make you wonder why you should even bother investing internationally.

Equities go through super cycles though and academics have been aware of this for some time. Although US stocks have reigned supreme for the past 10 years, it doesn’t mean they will do so going forward. The US outperformed international markets post the financial crisis and in the 90’s but apart from these time periods, international stocks offered superior returns. Just take a look at the monthly difference for the last 45 years to see.

Source: The Hartford

That 4.5% return on international stocks drove the target date index return down to 9.66% for the past decade but if the law of averages kick in soon, the best days for the target date funds may be ahead of it as valuations have become lofty in the US and the dollar has weakened.

Too Conservative– Then there just happen to be the fact that some people are just more aggressive with their investing, even if it’s their retirement at stake. A one size fits all approach may not working for those people. Personally I take the stance of being more conservative with retirement and more aggressive with other investments so you at least have something to fall back on but that’s just my personal preference.

Conclusion

As you can see the target funds do have their downsides. The private equity tilt which I discussed previously could be an interesting mix to throw into the investing pot. If you are worried about your target date fund, know it isn’t perfect but can provide a solid base for you to start with despite its flaws.

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