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But there is a problem with all that diversification. Namely, most target funds are chock full of actively managed mutual funds. Typically, actively managed funds underperform the markets as a variety of factors eat away their returns. Over time, especially for investors with decades to spare, that difference can make or break a retirement portfolio.
There is a solution, however: index your way to a better retirement.
There is now a whole host of index-based target-date funds on the market. And they could be an investor’s best friend.
The culprit for the benchmark miss was a combination of higher fees paid on actively managed funds and sheer human error. This is why many investors have been flocking to low-cost index funds, or those that track a specific stock or bond market benchmark.
Now, many target-date funds sponsors are offering TDFs that use only index funds as their holdings.
By using only index funds, these TDFs get the asset allocation right as well as reduce the chance for underperformance. An index fund will always return slightly less than its benchmark because there are still some fees associated with the fund. However, some index funds have expensive ratios of around 0.05%, or just $5 per every $10,000 invested. The difference is negligible. Additionally, the overall fee structure for index-based target-date funds is usually significantly less than their active rivals.
If your target-date sponsor picks the wrong horse, you could miss out.
You could also miss out if your sponsor does happen to have a few of the active managers that actually outperform their benchmarks. The ones who do manage to beat their benchmarks often do so by an average of 1.2% a year after fees. Compounded that’s a lot of return left on the table. And let’s not forget that index funds can’t save during market crashes the way an active manager can move to cash at the first sign of panic.
Finally, an index target-date fund could still become an overcomplicated mess, even though it’s designed for simplicity. Some TDFs will include an index fund tracking large-cap blend, large-cap value, large-cap growth, etc., and at the end of the day, investors are left with 16-plus funds. That many funds defeats the purpose of cost-saving indexing in the first place.