Why Target-Date Funds May Not Be Your Best Option

Every investor has different goals, and no one fund company has the best managers.

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Target-date funds are a great concept. If you're not familiar with them, here's how they work: You choose a fund based on a goal such as retirement or college savings and when you'll need the money. A fund with 2020 in the name means that's the year you'll want to use the money. The fund company takes your money and spreads it among funds in different asset classes from domestic and international, to large-cap and small-cap stocks, as well as growth and value styles all in a way that's appropriate for your time horizon and risk tolerance. Then, as your date approaches, the fund company changes the target-date fund's asset allocation to be more conservative. This means the target-date fund will gradually own fewer stock funds and more bond and money market funds as the investing period winds down.

The point of a target-date fund—one diversified fund that rebalances the asset allocation without you having to monitor it or make changes—sounds good. However, many target-date funds have not performed as well as they should. The problem is fund companies have not always done a good job executing the strategy. Here are a few reasons why many of these funds have had trouble:

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No one fund company has all of the best fund managers in every asset class. When you purchase a target-date fund, one fund company manages all the different pieces that go in it. This means that most target-date funds will invest in funds owned by one company. While a fund company may have very good fund managers in one particular area, it likely doesn't for all asset classes. A diversified portfolio should include the best funds in each asset class from different companies.

In addition, some companies use index funds and don't offer actively-managed funds in their target-date funds. Make sure to find out which funds are owned by the target-date fund. This kind of "one size fits all" fund advertised by companies may not be the best one for you.

A lot of the best fund managers work at fund companies that you've never heard of. Some little-known firms have the best managers in a particular asset class, such as small-cap funds. In addition, the smaller fund companies don't have a family of funds that cover every asset, so they don't offer target-date funds. That's why target-date funds tend to be offered by the largest fund companies, and that doesn't mean they're the best.

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Some fund companies lack asset allocation expertise. Most fund companies manage money by asset type. But that doesn't mean that a company has experts that can make decisions about asset allocation. For target-date funds to work properly, someone has to know how much money to put in stocks versus bonds, and also divide it by market-cap size and style (such as large-cap growth versus large-cap value stocks). Who makes those decisions? What kind of experience and knowledge do they have about making those decisions? Managing a good fund in one asset class is very different from deciding how to spread money among all types of investments.

Everyone has different appetites for risk and volatility. During the deep market declines in 2008 and early 2009, many target-date funds fell a lot more than investors liked. Each person reacts differently to that kind of volatility. You might stay calm during a market swoon and wait for a rebound. Or maybe you don't like to see any swings in your portfolio and prefer the funds to be more conservative. Meeting the different needs of many investors through the same group of funds is easier said than done.

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A target-date fund may not provide your ideal asset mix. To reach your goals, you might need to own more aggressive investments that carry higher risk than a target-date fund offers. Many target-date funds reduce the allocation to stock funds to 20 percent in their final years. This might not generate enough growth in your money that you'll need in retirement or for another goal.

However, when you're saving for retirement, I'd rather see you put money in a target-date fund offered in a 401(k) or IRA than pick the fund that did best last year and forget about it, like a lot of people do. Even if your retirement plan doesn't offer the best funds, having asset allocation and active rebalancing with a target-date fund is better than chasing last year's best performers and making uninformed decisions.

Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.