What is a target date mutual fund?
A target date mutual fund is an asset allocation fund in which the allocation changes over time. The date cited in the fund name refers to the time of the event for which you are saving; usually retirement but theoretically any big ticket expense. For instance, if you expect to retire in 2040 or have a child starting college in 2040, you might seek a target date fund with 2040 in its name.
Using assumptions consistent with the oft-used but foolish strategy known as age-based asset allocation, target date funds become increasingly conservative over time, shifting assets from stocks to bonds. For example, a fund 30 years from its target date might have 90% of its assets in stocks and 10% in bonds. A fund five years from its target date might have 30% of its assets in stocks and 70% in bonds.
Why you should avoid target funds
Dependence on a flawed principle
The chief operating principle in the management of target date funds is the steady shift of assets from growth-oriented securities like stocks to conservative income instruments like bonds. This shift occurs regardless of market conditions.
More importantly, the asset allocation ignores your risk tolerance. There are timid young investors. There are aggressive return maximizers already in retirement. With target date funds, nervous young investors suffer unwanted volatility, while nervy seniors see their wealth prospects needlessly reduced.
Figures 30-1 and 30-2 plot an assumed risk-appropriate allocation of 60% stocks/40% bonds versus the allocations over time in a typical target date fund. Whatever your tolerance level, the mindless adjustment of assets in a target date fund will leave you perpetually over- or underexposed to each of the major asset categories.
High fees for service provided
Most target date funds include bonds in the asset mix. Bond portfolios usually require less intense management than stock portfolios, so bond mutual fund management fees are a fraction of the rate charged by stock mutual funds. Yet most target date funds have expense ratios appropriate for 100% stock portfolios; an annual overcharge that worsens with time.
What you should do instead
First, do not use a calendar to determine the constituents of your portfolio. Ignore your birthday, your expected retirement date and any other date before or after. Since target date funds rely on a calendar for strategy, ignore them as well.
If you are already invested in or considering a target date fund as your holistic one-stop solution, the superior replacement strategy is a proper overall investment program. You can find such a program here.