Target-date funds are one of the fastest-growing segments of the mutual-fund industry, and it's easy to see why. They're a simple way to balance growth and safety, timed so that you can build assets when you're capable of sustaining risk but protect them as you get close to retirement. They're also the retirement savings option your employer will probably select for you if you don't make your own investment decisions for your 401(k) plan.
Target-date funds are composed of several stock and bond funds, some aggressive and some conservative. Depending on how many years before you retire, a fund manager sets your investment on a "glide path," the industry's term to describe the shift in asset allocation of a target-date fund over time. Say you expect to retire in 2040. Initially, the fund will be weighted toward stocks capable of big gains. You'll be exposed to more risk but you'll have the time to recover if stocks dip. Over the years, the balance will shift to fewer stock funds and more bond funds and cash to preserve assets and generate retirement income.
Fund managers rely on certain assumptions to set the course of target-date funds; the most important is how the stock market is expected to perform. That's always included ups and downs, with growth over the long haul.
We decided to find out how well target-date funds shelter investors during volatile markets like those we experienced in 2008 and during this past summer. We compared the performance of 156 of them from 26 fund families with the iShares Russell 3000 (IWV) exchange-traded fund, which in a sense is 100 percent stocks, zero percent bonds.
Like most investments, target-date funds had abysmal returns during the market upheaval three years ago. The average 2010 target-date fund lost 20 percent of its value, and one fund with that target date lost nearly 40 percent.
In the summer of 2009, hearings were called in Washington to find out why the funds had performed so poorly. The resulting regulatory changes were minor, but they did seem to prod fund managers into changing their allocation strategies. The glide paths of target-date funds have become more conservative, particularly those designed for investors planning to retire within 10 years. Of the fund families we examined, only the Vantagepoint Milestone and the Columbia Retirement Plus funds sport more aggressive glide paths than they did three years ago.
But there are still sharp differences in glide paths between fund families. We found that in 2009, AllianceBernstein had the most aggressive allocation strategy. For those on the cusp of retirement today, T. Rowe Price Retirement funds were the most aggressive. More than 60 percent of the assets in the 2015 fund are invested in stocks. Compare that with the most conservative 2015 target-date fund, Putnam RetirementReady, which has only about a quarter of its assets in stocks and more than two-thirds in conservative bonds and cash.
This summer, stocks tumbled around the world, losing more than 25 percent of their value in some countries. By comparison the U.S. market got off rather easily, with the Standard & Poor's 500 index losing only 14 percent from July through September. Most commodities faltered, and even gold tripped near the finish line. U.S. Treasury securities were the clear winners. Stock yields continued to fall, and since bond prices move in the opposite direction, bond funds did well. The Vanguard Total Bond Market ETF, for example, gained 4 percent.
Because target-date funds are diversified, holding a mix of stocks and bonds, their overall returns should at least be better than stocks alone at a time when stocks are falling in value. Diversified asset allocation is the primary strategy for achieving successful long-term performance. But in some cases, target-date funds weren't even able to outperform an all-stock, broad-market exchange-traded fund.
From July through September, the iShares Russell 3000 exchange-traded fund—which represents about 98 percent of all U.S. stocks—lost 15.1 percent. But during the same quarter, target-date funds held by investors with more than 25 years until retirement (for example, 2040, 2045, or 2050 funds) underperformed the ETF significantly.
Of the 39 funds in our screen, only two—the American Century Livestrong 2045 fund and the Franklin Templeton 2045 Retirement Target fund—beat the Russell 3000 ETF by more than one percentage point. Neither of their fund allocations was especially conservative. Both held a little less stock than the typical 2045 fund, which was 82 percent.
The two worst performers in this segment were the AllianceBernstein 2040 Retirement Strategy fund and the GuideStone MyDestination 2045 fund, which both lost more than 17 percent of their value. Those funds were among the more aggressive in their class. AllianceBernstein's funds are still the most aggressive of the 15 largest fund families. And curiously, the GuideStone 2045 fund has less than 1 percent in bonds (with a 5.4 percent cash position).
Funds designed for those retiring in the next 15 to 25 years didn't fare much better, even with lower stock holdings than the 2040 and 2045 funds. Despite an average stock exposure of only 78 percent, just half of the 14 funds dated 2035 were unable to hurdle the Russell ETF (see Underwhelming performance).
The 2020 target-date funds did outperform the all-stock ETF. One would hope so, because by then the exposure to bonds had increased to 34 percent, on average, and stock exposure had fallen to 57 percent. The only relatively good news we can report involves the funds designed for investors who are very near retirement. The returns were still negative—even 2010 target-date funds still had 20 percent to 50 percent of their asset allocation in stocks. But the returns were at least closer to what you would get by the most simple diversified investment possible: 50 percent invested in a broad stock-market ETF and 50 percent in a bond-market exchange-traded fund.
Why have target-date funds performed so poorly? One reason might be that they haven't always invested in the best funds a family has to offer. An example: With more than 100 Fidelity equity funds to choose from, the Fidelity Freedom 2025 target-date fund holds as many two-star funds as five-star funds, as they're rated by Morningstar.
Further, target-date funds are often invested exclusively in their families' own funds, which can be expensive. Of the 26 fund families that have offered target-date funds for at least four years, more than half have funds with expense ratios exceeding 1 percent, on average. This partly explains the difference in performance between the median target-date fund return last summer and that of two similarly allocated portfolios of two stock and bond ETFs (see Expenses matter).
Those costs are roughly the same as actively managed stock funds and more expensive than bond funds. The target date itself didn't matter: Expense ratios within a fund family were also roughly the same regardless of the fund's target date. Vanguard offers the most inexpensive funds. Its index-based target-date funds have expense ratios below 0.2 percent.
We analyzed the third-quarter performance of target-date funds from 26 fund families. More often than not, the funds weren't able to beat a broad-based, all-stock exchange-traded fund (iShares Russell 3000), which lost 15.1 percent in the quarter. The chart below shows the number of funds that performed better and worse than the ETF.
Last summer, if you took the average asset allocation of target-date funds and invested in just two low-cost ETFs—iShares Russell 3000 (IWV) and Vanguard Total Bond (BND)—you would have outperformed the median target-date fund by 2 to 4 percentage points.
This article appeared in Consumer Reports Money Adviser.