Investors in target-date funds can set up a diversified portfolio and maintain a sensible asset allocation for decades without breaking a sweat.
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By Karen Wallace | 05-10-17 | 05:00 AM | Email Article

Which is better--having a portfolio full of of topnotch, Gold-rated, low-cost funds, or having a sensibly diversified asset allocation? 

Karen Wallace is a senior editor with Morningstar.com. Follow her on Twitter @KarenW60602.

Though hopefully you would be fortunate enough to tick both of those boxes, if you own a collection of best-of-breed funds but don't assemble a good portfolio with them, you're only winning part of the battle. Target-date funds can help on both counts. 

Why Asset Allocation Matters
In their landmark 1986 paper "Determinants of Portfolio Performance," Gary Brinson and his colleagues concluded that a portfolio's static target asset allocation explained most of the portfolio's total return and volatility over time. Meanwhile, active investment decisions--security selection and timing--played only minor roles. These findings were confirmed in 2000 by Roger Ibbotson and Paul Kaplan. (Note: since this paper was published, Ibbotson Associates has become a Morningstar subsidiary.)

The takeaway is that an appropriate asset allocation is the primary driver of portfolio performance. In fact, it is more important than selecting the funds used to implement the allocation. 

What should an investor do with this information? The good news is that it makes a strong argument for using one of the simplest portfolio solutions.

How to Set Up and Maintain a Portfolio
Target-date funds can help retirement investors solve a few problems. With so many options on a retirement savings plan menu, it is hard to know what to choose. But selecting good investments is only one part: Investors must also pay attention to overall portfolio diversification and not take on too much risk by being concentrated too heavily in any one area.

How the investments correlate with one another is another consideration: Modern portfolio theory posits that an investor can optimize his portfolio's risk/return simply by selecting combinations of investments and asset classes that are not perfectly positively correlated; such a combination of assets is likely to do reasonably well in a variety of environments, because as one asset is falling, another is likely rising.

Once an optimal portfolio allocation is established, it's often advisable to rebalance back to the target allocations every year or so, and also to reduce exposure to risky assets as retirement approaches. Whereas early on investors are focused on amassing wealth, in the later stages the focus shifts to preserving it.

None of these tasks are impossible; certainly many investors manage their own portfolios and do it quite well. But there are a great many investors who would prefer to have help with the task of portfolio assembly, rebalancing, and gradually making their asset allocations more conservative. That's where target-date funds come in.

What Is a Target-Date Fund?
A target-date fund is really a fund made up of other funds. The underlying funds offer diversified exposure to a mix of asset classes such as equities (large caps as well as small-/mid-caps), foreign stocks, bonds, foreign bonds, and maybe a small portion of cashlike securities. They are designed to be held throughout the accumulation phase, and the asset mix shifts dynamically, becoming less risky over a person's working career and into retirement. These funds achieve this by rebalancing portfolios over time to become less focused on growth (in other words, lowering their allocation to stocks) and more focused on income (i.e., raising their allocation to bonds) as the fund approaches and passes the target date. (The year in the fund's name corresponds approximately to the investor's retirement date.)

Target-date funds have become increasingly popular in recent years. For one reason, the Department of Labor's Pension Protection Act of 2006 designated these funds as a Qualified Default Investment Alternative within 401(k) retirement plans, which generally allows plan sponsors to place participants into an investment when they do not make their own investment election. 

But their popularity also owes to their relative ease of ownership--they are truly hands-off investments that offer a diversified portfolio of building blocks with professionally managed allocations and automatic adjustments. As pointed out in the Morningstar manager research group's recently released target-date landscape report, assets in target-date mutual funds reached an all-time high of $880 billion by the end of 2016, up from $763 billion the previous year.

What to Look For
Though you may be limited by your plan choices, there are many characteristics that we pay attention to when we evaluate target-date funds. Here are some things to look for.

Low fees
Unlike buying a luxury car, paying a high price for an investment doesn't guarantee you a better ride. It's important to pay attention to the overall cost of the target-date fund. Some providers layer on fees, and the resulting price tag represents not only the blended costs of the underlying funds, but also a layer of management fees that the advisor charges to implement the asset-allocation glide path. Look for low fees. (Note that the funds that are closer to their target retirement age will tend to be less expensive overall than earlier-dated options because their asset mix starts to tilt away from higher-priced equity fare and toward lower-priced fixed-income options.)

For instance, Vanguard Target Retirement 2010 through 2060 options range from 13 basis points (or 0.13% of assets) to 16 basis points. The portfolio is made up of low-cost index funds, and Vanguard does not charge a management fee to handle the dynamic asset allocation piece for investors. Also, target-date funds built around index funds tend to be cheaper than those built around actively managed funds. According to Morningstar's target-date landscape report, the average asset-weighted expense ratio for target-date funds was 0.71% by the end of 2016. 

Asset mix that suits risk tolerance
Some target-date funds invest more aggressively than others. Funds in the Bronze-rated TIAA-CREF Lifecycle series and the Mainstay Retirement series have an equity allocation exceeding 90% equity for investors targeting retirement around 2060, while others (such as T. Rowe Price and Vanguard) are in the 80% range.

Investors can also drill down to the underlying exposure to foreign stocks (maybe your risk tolerance doesn't jibe with having a big stake in emerging markets, for instance) or fixed income (perhaps you would prefer to avoid high-yield bonds, as the Vanguard series does).

Check out the Portfolio tab on Morningstar.com's fund quote pages. There you will find statistics about the fund's portfolio. For instance, here is a quick peek at the asset allocation for Bronze-rated  MFS Lifetime 2035 A . You can see that stocks take up roughly 79% of the allocation from this big-picture view, and you can also drill down even further to see holdings by sector, country exposure, and market cap. (Click on the image below to see the Portfolio page.)

A glide path that makes sense
The rate at which a target-date fund adjusts its allocations to stocks and fixed income over time is known as its glide path. Check to see how the fund invests over time and ramps down its equity exposure as retirement nears. Some invest more heavily in stocks throughout the life of the fund in the belief that a higher equity position--and the higher returns that typically come along with stocks--is necessary to ensure that investors don't outlive their savings.

Morningstar can help with this assessment. For instance, check out these two glide path diagrams. (If you want a close look at the details, click on the image to go to the Portfolio tab on our fund quote pages. From there, scroll down to the bottom of the page to see a larger version of the image.)

This one is Silver-rated  Fidelity Freedom 2040 .

This fund continues paring its equity stake well past the target retirement date, and doesn't hit a static 20% equity weighting until 15 years into retirement. 

And this one is Gold-rated  BlackRock LifePath Index 2040 K .

Note that funds in this series halt asset-allocation shifts at the retirement date. Funds roll into  BlackRock LifePath Index Retirement upon reaching their respective target dates, and that fund keeps 40% of assets in equities throughout the retirement phase.

One-Size-Fits-Most
For many investors, target-date funds make a lot of sense, but they may not work for everyone. Outside of initially picking the fund, they don't offer investors control over their investment or allocation choices. By choosing a target-date, investors are essentially limited to a given fund family's funds (most target-date funds are fettered, meaning the fund companies use their own underlying funds to build portfolios). Few fund companies offer best-of-breed funds across all asset classes.

In addition, they are intended to be used on their own. If satellite holdings are added--perhaps to add exposure to market sectors not represented in the target-date fund's portfolio--investors must take on part of the rebalancing task by recalculating the asset allocation of the entire retirement portfolio to make sure it's in line with targets. (Morningstar.com's Portfolio X-Ray tool can help.)

Also, as Christine Benz points out, target-date fund investors who are in retirement and taking distributions don't have the flexibility to sell specific assets that have appreciated and may be ripe for a fall. Rather, by selling or taking distributions from the fund, they essentially are reducing their exposure to all asset classes in equal proportion.

Those caveats aside, target-date funds offer a great proposition for most retirement savers. They are no doubt the easiest path to setting up a diversified portfolio and maintaining a sensible asset allocation for decades.

Further Reading

 

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