The Problem with Target Date Funds

by David Strege, CFP®, CFA, CKA®, Senior Financial Planner | April 8, 2015

Syverson Strege and Company | Sherpa Investment Managem

Many times we see people that have selected a Target Date Fund (TDF) for their retirement plan figuring this is a good diversified choice.  At the Financial Advisor Retirement Symposium, Rob Arnott explained the problems with Target Date Funds.  We agree with his assessment and recommend that these investments not be used. Here is why:

The concept of these funds is to reduce the exposure to stocks as the target date approaches.  The research shows that only considering age is a poor one factor choice.  There are other ways to improve performance potential over time as a goal approaches.

Diversification needs to be improved.  TDF normally only invest in a mixture of stocks and bonds.  These two investments are weakened right now by low yields.  They will also crumble when inflation increases.  There are other assets classes that can be included to provide better risk adjusted returns.  These include managed futures, commodities, REITS, Bank Loans, TIPS and High Yield bonds.  Currently, we are including managed futures and inflation protection through all asset authority movements.  Adjustments to the asset class participation needs to occur as valuations vary and relationships between asset classes change.

How selection occurs within each asset class has profound effects.  Capitalization weighted indices serve as the basis for TDF result in return drag.  Capital weighted indices overweight overpriced securities and underweight underpriced ones, relative to the fair value weight. Any non-price-weighted approach produces better long term results than cap weighting.  We utilize RAFI weighting which build the index based upon the  economic imprint of the company.  This provides a value tilt.  Capital weighting has a growth tilt. The RAFI all world stocks outperformed capital weighted by 1.43% a year during a period when value stocks overall underperformed growth stocks by -.52% a year.

TDFs have higher fees that formulate into lower returns to the end investor. TDF industry average asset weighted expense ratio at the end of December 2013 was .84%.  When the Vanguard group of TDF are removed the remaining TDF expense ratios average 1.14%.  This is why we are looking into investments that have lower expense ratios like RAFI fundamental indexes through Exchanged Traded Funds (ETFs).

These problems are why we recommend that people not use Target Date Funds when an investment professional is available to help.

– David Strege