17 October 2017

TDFs: Same Target Year, Wide Variation in Results

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Two target-date funds with the same retirement year won’t necessarily achieve the same performance. In fact, the difference in results may be quite significant.

Target-date funds typically comprise cash, stocks and bonds in a portfolio that becomes more conservative as the retirement date chosen by the investor nears. Such funds became popular when the Pension Protection Act of 2006 allowed them to be offered as the default investment option in various retirement plans, including 401(k)s.

Target-date-fund providers say investors can easily put together a suitable portfolio simply by choosing a fund that corresponds to their expected retirement year; then, after they select a fund, they can just let it ride while the fund managers adjust the asset allocation to become more conservative as the years go by.

But firms can use very different formulas within this broad framework, which means investors need to take a closer look. "What they own or don't own, and how much of it they own, dictates performance," says Phil Chiricotti, president of the Center for Due Diligence, a firm that serves the retirement-plan industry. In 2013, when the S&P 500 soared more than 30%, it's no surprise that target-date funds with a heavier U.S.-equity allocation did particularly well.

Those big 2013 gains also largely explain how funds stack up for the 12 months through April. For example, American Funds 2025 Target Date Retirement rose 14.9% in the 12 months through April, making it the best performer among its peers, according to Thomson Reuters Corp.'s Lipper unit. At the bottom of the group, Pimco RealRetirement 2025 rose 1.4%. The two funds recently had 81% and 12%, respectively, allocated to equities, according to Lipper.

Indeed, over the past five years, the range of returns among funds with the same target year has increased, in part because more funds have come into the market.

Some are using different investment strategies to stand out in an increasingly crowded market, and differences in the performance of equity and fixed-income markets have played a big part as well.

“The Big Three,” and Others

The target-date-fund space is dominated by three big players: T. Rowe Price Group, Fidelity Investments and Vanguard Group. Their funds' performance has been similar so far this year, though T. Rowe Price has been slightly heavier in equities. Overall, assets in target-date funds climbed to $644 billion as of March 31, from $248 billion in 2009, and the big three players account for about 73% of those assets, according to Lipper.

As other providers try to gain market share, some target-date funds are trying to stand out from the pack by using unusual investment approaches. But diversifying beyond ‘plain-vanilla’ stocks and bonds last year, into areas like emerging markets, real estate, Treasury inflation-protected securities, natural resources and commodities, generally reduced performance, says Mr. Chiricotti. Many bond investments lost money as some interest rates rose, depressing prices. That in turn hurt funds aiming to be more conservative, who tended to hold more dollars in bonds.

At the same time, some fund managers emphasized the view that minimizing losses matters more than gains when trying to accumulate capital or derive an income from a portfolio, and that a stock-heavy allocation will provide not only higher gains in some years, but larger losses in others, potentially throwing a target-date fund off track.

Changing Fortunes

Retirement savers should not forget that an asset class that is a drag in one year could fuel a fund's performance in the next. Moreover, investors should not count on stocks performing as well this year as they did in 2013, and so they may want to scale back expectations for equity-heavy target-date funds. So far this year though, there haven't been large variations between the best and worst-performing target funds.

More generally, in selecting a target-date fund, investors should above all pick one that suits their risk tolerance and fits with their overall portfolio. They should be comfortable with the fund's "glide path," or how the fund resets its asset mix to become more conservative as the investor nears retirement.

There is no one formula that is universally ideal, as people have different goals and needs. But familiarity and comfortability with the fund’s broader strategy will help investors stick with it for the long term, which is important since bailing out in a down year is usually counterproductive.

And, of course, never forget that fees eat into returns regardless of what's happening in the market.

Don't chase performance, and always look for low fees.

This article includes information drawn from research in the Wall Street Journal.

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