Target Date Funds Misunderstood

Traders Crop Time to revisit target date funds. I wrote about them three years ago. Come to think of it, I did it twice.

I have a lot of issues with target date funds. These are asset allocation mutual funds that contain a mix of stocks and bonds, and sometimes more exotic things, formulated to meet the investing needs of a person intending to retire in a given year.

To begin with, I object to the basic premise, that a manager can select a risk-return tradeoff for an investor based only on his expected retirement date. Partly, this is because I am not a believer in the conventional view that a person should take a lot of investment risk when young and less as they age. But I concede that I belong to the radical fringe on that particular subject.

Yet, even if you accept that knowing that a person plans to retire in 2035 tells you something about what level of risk is appropriate for that person’s mutual fund, it should be clear that it does not tell you everything. Other factors, such as how much the person has saved already and how long they expect to live in retirement after the target date would rationally have a big role to play.

Then there is the implausible and unstated conceit that the target date fund contains substantially all the saver’s assets. This is obviously rarely the case in the real world. Even if you could know the correct risk-return tradeoff for a person because you know he will stop working in twenty years, there is not much you can do about it unless you know if the other half of his assets are in stocks, bonds, real estate, or antique dolls.

And even if I set aside my fundamental objections to the basic idea, I have a big problem with the way that most target date funds are constructed. Generally, the funds are implemented as a fund-of-funds, a pre-selected basket of a mutual fund complex’s regular mutual fund offerings.

And that means that there is an unavoidable conflict of interest. A company might have any number of reasons to put money into one of its funds other than what is best for the client. For example, the company gets paid higher fees on some of the funds. Indeed, as a general rule the higher risk funds have higher fees, so the mutual fund company will be paid more the more risk it decides the client should take.

All this venting of frustration was brought on by a recent item in the WSJ’s quarterly mutual fund survey One Target, but Many Ways to Hit It. The piece is mostly a round-up of the current approaches of the major target date vendors, but it starts with revealing the apparently non-obvious fact that different target date managers invest in different things.

This echoes a shocking finding in the Times from three years ago, that “Data collected by the S.E.C. shows that target-date funds vary widely in terms of their investment risks, even when they use similar target years or names.”

Would newspaper readers be similarly surprised to read that different stock fund managers not only buy different stocks but sometimes have wildly different, even conflicting, investment philosophies?

Target date funds have been around for a long time, as long as I can remember. But they became a big deal in 2006. That was when our government decreed that 401k plans, which until then used cash as the default investment, could put the savings of employees in target date funds if they otherwise failed to state a preference.

Based on exhaustive quantitative research, I have determined that 2006 was just six years ago. It sure seems longer, like some far off magical land. In those days there was a serious concern that putting worker’s savings into an investment whose only virtue was that it could not lose value was doing that worker a disservice. Some, if not all, of the savings should be put in something with a higher expected return. That way, even if the poor dear is not sophisticated like us, he can share in the unlimited bounty that is the stock market.

I am pretty sure that Congress would enact nothing of the kind today. Cash as default sounds like a good idea after all. It may not be ambitious, but the possibility of robotically losing somebody’s savings on autopilot is not acceptable.

More interesting, and frankly confusing, to me is the continuing misunderstanding over the nature of target funds. Congress seemed to believe, and the media apparently continues to believe, that the appropriate asset mix for a person planning to retire in a given year is a relatively simple question with a correct answer. As if there was a broad consensus on what percent of assets should be in bonds for somebody planning to retire in 2030, possibly subject to tweaks at the margin. Like the question of how big a size L tee shirt should be. There is no precisely correct answer, but all reasonable answers fall into a pretty narrow band.

In fact, there is no consensus answer to the question of how much risk a person retiring in 2030 should take. Clowns like me are even willing to argue it is the wrong question to ask. And target date funds are still mutual funds like any other, run by managers with widely differing views on what strategies are best and how to implement them.

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