Look out for ETFs Within Pre-packaged Target-Date Funds

There’s no question that target-date funds have been one of the industry’s more positive developments. They give the average investor a cheap way of building a broadly diversified portfolio that becomes less risky as the goal date approaches. They’ve become a great “set it and forget it” option for investors who don’t want to deal with the hassle or confusion.

This doesn’t mean, however, that they’re perfect investments. Many providers build very different portfolios based on the same target date, while some still charge unnecessarily high fees. The choice to add ETFs to target-date funds in order to lower costs sounds like a good idea on the surface, but it doesn’t necessarily work for everyone.

You can read on how target-date funds work to familiarize yourself with this class of mutual funds.

With many companies racing to charge the lowest fees – Fidelity, Schwab and TD Ameritrade, among others, just reduced commission costs, while Vanguard lowered expense ratios on several of its ETFs – some fund providers have begun adding low-cost ETFs to their target-date funds. Generally speaking, ETFs tend to have slightly lower expense ratios than their mutual fund counterparts, but not in all cases. Investors need to take a close look at the fund’s structure to determine if a target-date fund filled with ETFs is best for them.

See how cross pollination between mutual funds and ETFs works.

The main driver for the switch to ETFs is cost savings. With the average target-date fund charging 73 basis points, the addition of ETFs helps lower the overall expense ratios of the target-date funds.

The BlackRock LifePath Series and the Schwab Target Index Funds are two groups of target-date funds that have recently made the switch to ETFs. BlackRock made the change not only to focus on low fees, but also to offer varying degrees of active management within the products. The LifePath Index funds will use traditional index funds to provide market exposure, while the LifePath Smart Beta series will use more actively managed smart-beta ETFs to try and beat the market.

Schwab’s decision came down, primarily, to fees and simplicity. Employer-sponsored plans will be charged just 8 basis points for the new TDF funds regardless of overall plan size. This is a big advantage for smaller retirement plans, which typically didn’t receive the pricing advantages that larger plans did in the past. Individual investors, who would be charged 13 basis points, also get a low-cost alternative.

Target-date funds using ETFs also have the advantage of greater transparency. Collective investment funds have become increasingly popular among plan providers who wish to have more control over their target-date fund offerings. Those funds, however, don’t have the fiduciary requirements that traditional target-date funds do. ETF-based target-date funds likely do a better job of giving investors greater visibility into the products and also help address the recent spate of 401(k) litigation cases by providing greater transparency into their products.

Read about important questions you should ask your target-date fund provider.

Bigger retirement plan providers may not see much benefit in offering the new funds within their plans. In most cases, large retirement plans already come with rock-bottom fees, to begin with, so they may have little need for a new target-date fund. The $216 billion Vanguard Institutional Index fund, one of the most popular funds within employer-sponsored plans, already charges just 0.04% on balances over $5 million for Institutional Shares. The Schwab funds, for example, may be of interest to smaller plan providers who don’t currently have access to that kind of low-cost option, but bigger plans may already be paying a much lower fee.

Learn about the pros and cons of ETFs compared to mutual funds.

Another example would be retirement plans that use collective investment funds. Providers likely built them with their own participant base in mind and have already negotiated ultra-low fees. In these cases, target-date funds using ETFs may not pique much interest from the provider.

Check out our Retirement Fund section to read up on the different types of pre-packaged target-date funds.

Large retirement plan providers may not have much need for an ETF-based target-date fund, but most retail investors might. For products intended to be held for decades, every reduction in fees could add up to thousands of additional dollars in retirement savings. ETFs often come with lower expense ratios than mutual funds, especially actively managed ones, so a target-date fund containing ETFs may hold a particular advantage for long-term investors. These funds can also provide a broader array of investing options and a better risk/return profile.

In case if you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.

Fees and expenses are some of the biggest roadblocks to building retirement savings, so any development that lowers fees for the majority of investors should be applauded. The industry continues to progress toward ultra-low-cost products. Target-date funds that use ETFs are another step in that direction.

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