Know the Composition of Your Target-Date Fund Over Time

Since target-date funds are constantly rebalancing over time, we’ll highlight throughout this article the importance of knowing a fund’s structure in comparison to its peer group.

In order to better understand how similar target-date funds can significantly differ in performance because of a varying asset allocation mix over time, let’s consider the following example.

To compare the differences in asset allocation and glide paths between funds, the following three 2055 target-date funds are being compared.

Note: Each fund has the purpose to help someone planning to retire in 2055, or 39 years from now.

Fund Expenses and Asset Management Strategy Is Key

In the example above, the three 2055 target-date funds have the same objective, yet they can produce very different returns. This warrants an analysis of the funds’ compositions and glide paths.

Consider this. The Vanguard fund adjusts its asset allocation between only four index funds, making this passive strategy a cost-effective one with a mere 0.16% expense ratio. On the other hand, Fidelity and Schwab funds use an active managed approach with a mix of both index funds and actively managed mutual funds in other asset classes.

One disadvantage of such a hybrid strategy can be higher expenses. For instance, the Fidelity fund allocates assets to a broad variety of asset classes (i.e. mid cap, small cap, real estate, emerging markets and floating rate instruments), bringing its expense ratio to 0.77%. Given this, you might want to know what asset allocation really means for mutual funds.

So if you like taking risk and have enough confidence in the stock market’s long-term performance, you can go for Schwab’s more aggressive strategy. On the other hand, if you happen to have a low risk appetite, the Vanguard fund would be the better option because of its lower allocation to stocks.

Like other investments, target-date funds should be monitored on a regular basis, especially during challenging economic conditions. To explain this, let’s again consider the above-mentioned target-date funds. Since the three target-date funds have a shorter track record, we will use the returns of 2014 and 2015 to compare the changing market conditions.

In 2014, the S&P 500 index had excellent returns with the index up 13.69%. The next year was more challenging and volatile for investors, with the Index returning only 1.4%. Out of the three funds, the top performer in 2014 was the Vanguard fund (7.19%), followed by the Schwab fund (6.65%) and the Fidelity fund ( 5.75%). However, during the more trying 2015 year, the best performing fund was Fidelity’s (-0.20%), followed by Schwab’s (-0.40%) and Vanguard’s (-1.72%).

The pattern suggests that asset allocation policy along with active and/or passive management strategies played a crucial role in explaining the performance differences. For instance, the Fidelity fund was able to restrict its downside in the volatile year yet underperformed in the up year, suggesting that the glide path might be of a more conservative nature.

This brings out yet another aspect of these funds that investors need to perform, i.e. proper due diligence. Doing so can help an investor have a complete picture of the chosen target-date fund as they will be encouraged to monitor and compare fund performances during both the good years and the bad. In this context, you might want to read more about the due diligence procedures of a target-date fund.

Each target-date fund has its own glide path strategy, which can affect its performance over the fund’s lifetime. Vanguard, for example, breaks down a glide path into four periods: young, transition, early retirement and late retirement. The young portion is when the investor is between the age of 25 to 40 and has the highest concentration of stocks in the portfolio. From there, the portfolio gets gradually more conservative until the age of 70, at which time the allocation becomes fixed at 30% stocks and 70% in bonds and cash.

It is also crucial to analyze the fund’s investment strategy and whether it follows an active, passive or hybrid approach. In our example above, the Vanguard fund is comprised of four index funds that are designed to mirror an index. The Fidelity fund is comprised of several actively managed funds, of which each has its own track record. In this context, it becomes important to take note of historical performance. For active management, prior performance of the fund in good and bad years should guide your future expectations; while for passive management, it’s important to keep tracking error over time and conduct peer comparison.

Understanding the fund’s glide path will help you to decide if the fund is capable of helping you achieve your investment goals. For example, will a portfolio of 70% bonds be enough to sustain your retirement spending capacity after the age of 73? Or does the glide path meet your risk tolerance needs, especially during the early years when the portfolio is invested primarily in stock?

Before you jump into choosing a target-date fund, you should factor into your analysis how the fund’s glide path is supposed to be managed over time, whether passive/active strategy adopted by the fund is right for you and what portion of your target-date fund should be actively/passively managed.

Performing an in-depth analysis of the fund’s current composition, as well as its glide path, will help you decide if a particular target-date fund is the right fit for both your investment goals and risk tolerance. To a large extent, the glide path of a target-date fund is useful in explaining how the asset allocation would change given your specific requirements.

However, be aware of the fact that not all target-date funds are made the same due to the different investment strategies of each fund company. Some are passive, like Vanguard’s or actively managed, like Fidelity’s.

Be sure to follow our Target-date Funds section to make the right investment decision.