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For many investors who are saving for retirement, a target-date fund is the biggest component of their portfolio.
If your investments are in a 401(k) or similar retirement plan, you may not have a choice of fund companies. Your only choice may be the target year…as in do you want a 2055 fund, a 2060 fund, or something else?
But if you’re looking for a target-date fund for an IRA, you can choose not only your target date, but the fund company itself. How you make this choice can matter a lot.
This is a quick guide for shopping.
I think the most important factors to look for, roughly in this order, are:
• Low expenses;
• Passively managed underlying funds;
• A glide path with low exposure to cash and bonds in the early years;
• Exposure to value stocks and small-cap stocks;
• A low minimum to open an account.
Expenses
Any mutual fund’s recurring expense ratio is like the leak in the bottom of a bucket that eats away at your nest egg year after year after year.
When I compared expense ratios of comparable target-date funds at Charles Schwab SCHW, -0.75%, Fidelity, and Vanguard, I found expenses ranging from 0.08% (Schwab) to 0.15% (Vanguard).
Passive management
To me it is obvious that active management, with its inevitably higher costs and dubious probability of matching (let alone beating) the averages, is a bad idea.
Yet some target-date funds are built of actively managed funds.
My advice: Before you invest in a target-date fund, double-check to make sure its underlying assets are index funds.
Cash and bond exposure in early years
Ideally, a target-date fund would invest entirely in equities until at least 30 years before the target year when shareholders presumably will begin making withdrawals. But typically, target-date funds hold some of their portfolios in cash and bond funds much earlier than that.
The rationale may be to reduce investment risk. But holding 10% of a portfolio in cash and bonds fails to provide any meaningful protection from bear markets.
Meanwhile, the cash and bonds reduce returns, robbing investors of the full opportunity for long-term growth of their savings.
Not all target-date funds are the same in this regard. In comparing three 2060 funds, I found cash-and-bond percentages ranging from 4.9% (Schwab) up to 11.2% (Vanguard).
Diversification of equity asset classes
Most target-date funds’ equity portfolios are heavy on giant-cap and large-cap funds. Although it can take a little digging to uncover the details in a target-date fund’s underlying holdings, this is important.
I believe the equities should be tilted toward small-cap stocks and value stocks. The first can be measured by a statistic called the median market cap; the second can be measured by the portfolio’s price-to-book ratio.
For each of these measures, a lower number is more favorable than a higher one.
Low minimum balance
For retirement-plan participants, this is not an issue. But if you’re shopping for a target-date fund on your own, you shouldn’t have to save up a lot of money in order to start. Fortunately, it’s easy to find target-date funds with reasonable minimum investment requirements.
Three 2060 target-date funds: How they stack up
I applied these criteria to 2060 funds offered by Fidelity, Schwab, and Vanguard. None of them uses actively managed mutual funds or exchange-traded funds (ETFs).
I measured each portfolio’s equity size by median market capitalization (lower is more desirable).
Schwab Target 2060 Index Fund SWYNX, +0.74%
• Expenses: 0.08%
• Cash and bonds: 4.9%
• Price-to-book ratio (value orientation): 2.26
• Median equity size: $46.7 billion
• Minimum opening balance: $1
Vanguard Target Retirement 2060 Fund VTTSX, +0.65%
• Expenses: 0.15%
• Cash and bonds: 11.2%
• Price-to-book ratio (value orientation): 2.21
• Median equity size: $45.7 billion
• Minimum opening balance: $1,000
Fidelity Freedom Index 2060 Fund FDKLX, +0.60%
• Expenses: 0.12%
• Cash and bonds: 10.5%
• Price-to-book ratio (value orientation): 2.27
• Median equity size: $54.0 billion
• Minimum opening balance: $1
How to choose
The most meaningful differences among these three funds are in their expense ratios and their cash-and-bond exposure. Fortunately for shoppers, those are the two most important variables.
The clear winner in my estimation is Schwab, with its low expenses and higher proportion of equities. The Vanguard and Fidelity funds are very similar, though Vanguard has an edge in terms of owning smaller companies.
Vanguard’s target-date funds also diversify their bond portfolios by including international bonds and U.S. Treasury inflation-protected securities (TIPS), each of which may benefit investors who are nearing retirement or already retired.
It should be no surprise that these funds performed very well last year. The Schwab and Fidelity 2060 funds each gained 26.1%, while the Vanguard fund was close behind at 25%. The three-year trailing returns of the three funds were within 0.4 percentage points of each other.
Although Schwab is my first choice, I can recommend all three.
One common shortcoming
There’s a significant flaw in target-date funds, a shortcoming that derives from my belief that younger investors have different needs for equities than older ones.
When you’re young, you will benefit from an equity mix that emphasizes small-cap companies and value companies. When you’re older, I think your equity assets should look more like the S&P 500 index SPX, -0.17% or the Total Market Index.
Every target-date fund gradually reduces risk over time by transitioning the portfolio from equities to bonds. I think the makeup of the equity investments should also evolve over time to reduce risk.
Target-date funds could easily make this transition as their shareholders grow closer to their target dates. But I have not found any fund that does this in any significant way.
That’s the bad news. The good news is that with very little work, investors can overcome this shortcoming. .
Richard Buck contributed to this article.
