Thursday, February 16, 2012

Why target date funds are like hotdogs.

Target date mutual funds are portfolios of funds that adjust the allocation to stocks and bonds based on how close the fund is to its specific target date.  These funds are, in theory, great for people saving for retirement, as they gradually reduce the risk exposure of the fund as the retirement date gets closer.  By buying a target date fund, the retiree doesn't have to worry about rebalancing his/her portfolio each year.

This article explains the idea pretty nicely and contains a graphic showing how the allocations might change over time.

So what's not to love about target date funds?  A lot actually.   Ron Elmer has done a nice investigation of exactly what goes into one of these funds.  You can read it here.  The analogy I'd like to make is one of making hotdogs.  The good cuts of meat (the good funds) are generally sold directly to the public, but the nasty stuff is mushed up and put into hotdogs (target date funds).   To understand why this is so, you need to know a little bit about how mutual funds come and go.  

Most mutual fund companies are constantly starting new funds.  But no one wants to put money in these new funds because they don't have a track record.  In addition, because they are small, their expense ratios are often pretty high.  But the mutual fund company can stick these start up funds in a target date fund.   Because people buy the target date fund without paying attention to the funds within the fund, they will put money into these start up funds.  The start ups that do well will most likely be sold directly to investors (these turn out the be the good cuts), but the ones that do badly will be closed or folded into other funds and replaced with a new startup.

As a result, at least for the target date fund that Ron looked at, the fund is heavily weighted towards new, high fee funds that have poor track records.  Case in point, the Fidelity Freedom 2035 fund has an expense ratio of 0.77% which is basically the average of the funds it contains.   This is much higher than the expense ratio of an equivalent portfolio of index funds.

As a side note,  the Fidelity Freedom 2035 fund is one of the options offered to employees at my institution.