Target Date Funds – Why I do not like them

by Evan on September 26, 2009

I have never been a proponent of target date funds. Let me explain why in this blog entry.

When you purchase a target date fund you buy into a mutual fund that holds other mutual funds. Sound complicated? It is! The underlying funds are supposed to be placed into each target date fund based upon a specified target future date (ie 2010, 2015, 2020) that corresponds to the investors approximate date of retirement.

Here are the three reasons I do not like these funds:

1.) Each individual has different risk tolerances or ability to handle the ups and downs in the markets. These target date funds are generic both in content and risk for a specified age grouping. This means that if you want to be highly aggressive, not the norm, the target date funds will not work for you.

2.) Recently, during the market down turn of 2007-2009, target date funds developed for very conservative investors lost a great deal of their investment! It was not uncommon to have people who were 55-60 years of age that lost 25-30% of the target date funds value in under 12 months. These funds are flawed with respect to making assumptions about future growth based upon past growth rates. Thus, if the growth rate going forward is lower than the established historical growth rates, as I think they are, the target date funds will take on more risk for each amount of potential return.

3.) There is something called cash drag. Cash drag is related to the amount of cash that is held in each mutual fund that the target date fund invests in. Without looking at each individual fund to find out how much cash is held, the investor never knows how much is truly invested in the market versus cash. So even though the target date fund might try to replicate a 60% equities/30% bonds/10% cash strategy, the underlying funds may “drag” the total % of cash out to be something like 13%. Thus, you think that you are investing in a 60%/30%/10% but you are really invested in a 57%/30%/13% fund instead. Over time, this affects investment return and exposes the investor to additional inflation risk.

In closing, there are better options for investors in the investment universe.

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