Target funds miss the mark
Portfolio managers who committed too much money to stocks in search of extra gains inflicted big losses on investors nearing retirement.
(Fortune Magazine) -- Target-date funds, also called life-cycle funds, are supposed to ease your troubles. You park your money in one, and the fund manager rebalances your portfolio over time, moving your assets from stocks to bonds as you approach your retirement. But for many target-date investors in their sixties, those years will now be spent trying to recuperate losses of 25% or more in 2008 - which were incurred in part because their funds were treating them like 30-year-olds.
"The typical target-date fund is overly aggressive," says Craig Israelsen, a Brigham Young University professor and the founder of research firm Target Date Analytics. "Managers were betting that if they were in equities, they'd perform better - and they got nailed, along with everyone else. The problem is, they were nailing people in their sixties and seventies."
According to Israelsen, the average 2010 fund - marketed to investors who were aiming to retire next year - was more than 45% invested in stocks in December. As of March 2008, the mammoth Fidelity Freedom 2010 Fund (FFFCX) housed 50% of its assets in equities, and AllianceBernstein's 2010 portfolio (LTDAX) was 57% in stocks in February of last year. The funds lost 25% and 33%, respectively, last year, barely beating the S&P 500.
That dismal performance has drawn notice in Washington. Wisconsin Senator Herb Kohl, who heads the Senate special committee on aging, asked the SEC and the Department of Labor in February to investigate target-date funds. (Secretary of Labor Hilda Solis agreed on March 26 to begin a probe.)
"These emerging products have the potential to help millions of Americans, particularly those with low financial literacy, save for their retirement," wrote Kohl in a letter to Solis. "But in order for such funds to be successful, there must be effective oversight."
Why would a senator take an active interest in a class of mutual funds? For one thing, Washington helped make target-date funds popular with the Pension Protection Act of 2006, which allowed employers to make them the "default option" in their 401(k) plans - the investment for participants who do not specify other choices. Partly as a result, target-date funds have proliferated. Morningstar analyst Greg Carlson says that of the 380 target-date funds, more than 300 are less than five years old. "Despite what happened in 2008, I don't see their popularity waning," he says. "Investors are attracted to low maintenance."
Many money managers say that the fund class's weak performance last year was caused by poor execution, not the underlying concept. "The idea still has a lot of promise," says Kevin Price, chief investment officer at Interlake Capital Management. But Price notes that funds are usually marketed on performance, which may have led managers to take added risk in search of extra return. "These products were built to be sold," he says, "which is one of the reasons they were overexposed to equities."
In response to allegations that they took too many risks, fund managers argue that retirees are likely to live for another 20 or 25 years after they stop working - which is why it's better to hit the target date with a big equity stake. But Ronald Sweet, manager of USAA's target date funds, says fund managers should have been prepared for older investors to withdraw their money in the case of a slowdown. "We never bought the argument that people nearing retirement should have much in stocks," says Sweet.
Another defense that's cropping up: 2008 was a once-in-a-lifetime event that left no asset unscathed, save Treasuries. "Clearly we're disappointed that we saw the results we did," says Mike Finnegan, one of the managers of the Principal Lifetime 2010 fund, which lost 31% of its value last year. "But just about everything struggled. And if you weren't invested in the life-cycle funds, where else would you have invested?"
Bonds did fall last year, although funds with more of them were better off. Wells Fargo's Advantage Dow Jones Target 2010 (STNRX), which had 61% of its assets in bonds last February, lost 11% in 2008, beating the group average. Another fund that played it safe was Deutsche Bank's DWS Target 2010 (KRFAX), which had 79% of its holdings in government and agency debt last July and dropped just 4% last year.
The lesson here is that even with investments that are meant to put you on autopilot, you have to be alert. When choosing a target-date fund, make sure the asset allocation fits your own idea of what's sensible for someone your age.
And keep an eye on expenses - as a rule, says Carlson, seek out low-cost target-date funds like Vanguard's Target series (WTWNX), where expense ratios are, per the house style, around 0.2%. Vanguard's costs are low because it puts most of its target-rate assets in index funds, which passively track stocks.
Interlake's Price says he "overwhelmingly prefers funds invested in indexes," and not just because they're cheaper. "Too often these funds are stuffed full of expensive, proprietary funds," he says. "With indexes, you know exactly what you're getting."