What is a Target Date Fund?
A target date mutual fund is a type of fund that invests in a mix of stocks, bonds, and other securities, and gradually shifts from more aggressive to more conservative as you approach your target date. The idea is to reduce the risk of losing money when you are close to your goal and need to withdraw your funds.
How do target date funds work?
Target date funds are designed to simplify your investment decisions and provide a diversified portfolio that matches your risk tolerance and time horizon. You only need to choose a fund that has a date close to your goal, and the fund manager will take care of the rest. The fund manager will periodically rebalance the fund to maintain the desired asset allocation and respond to market conditions.
For example, if you plan to renovate your home in 2027, you can choose a target date fund with 2027 in its name. The fund may start with a high allocation to stocks, such as 80%, and a low allocation to bonds, such as 20%. This will allow you to benefit from the higher returns of stocks in the long run, while taking some risk. As you get closer to 2027, the fund will gradually reduce the stock allocation and increase the bond allocation, such as 60% stocks and 40% bonds in 2025, and 40% stocks and 60% bonds in 2027. This will help you preserve your capital and reduce the volatility of your portfolio, while still generating some income.
Risk tolerance over time
Following its launch, a target-date fund typically exhibits a high tolerance for risk, heavily investing in high-performing but speculative assets. Portfolio managers adjust the investment categories annually, resetting the allocation to align with the fund's objectives. As the fund approaches its objective target date, its asset mix gradually becomes more conservative.
Higher-risk portfolio investments usually comprise domestic and global equities, while lower-risk segments include fixed-income investments like bonds and cash equivalents. Fund marketing materials often illustrate the allocation glide path, showcasing the gradual shift in asset allocation throughout the investment horizon.
Target-date funds are designed to achieve the most conservative allocation at the specified target date, ensuring a balanced approach. Some funds, referred to as through funds, continue to manage allocations beyond the target date, emphasizing low-risk, fixed-income investments. Conversely, ‘to funds’ cease any adjustments to asset allocation once the target date is reached, maintaining the risk profile established up to that point. This strategic approach helps investors navigate their risk tolerance while aligning with their long-term financial objectives.
Advantages and disadvantages of TDFs
Advantages
Target-date funds (TDFs) are increasingly popular among 401(k) plan investors, especially those who prefer not to review their fund holdings annually or adjust their investment strategy. TDFs automate the investment process, allowing younger workers to select a target-date 2065 fund, while older workers might choose a target-date 2030 fund.
For many, TDFs serve as an effective retirement savings vehicle, reducing the need for an additional backup plan alongside a 401(k). Financial experts often recommend that if you only invest in one long-term savings option, it should be a target-date fund for optimal convenience and management.
Disadvantages
The autopilot nature of target-date funds can be a double-edged sword. While they automatically adjust portfolio assets over time, this predetermined strategy may not align with an individual's evolving goals and circumstances. For instance, retiring earlier than expected or choosing to work longer can disrupt the intended benefits.
Additionally, there are no guarantees that a target-date fund will deliver a specific income or returns, as it functions as an investment, not an annuity. Like all investments, target-date funds carry risks and the potential for underperformance, necessitating careful consideration before committing funds.
Pros and cons of target date mutual funds
Target date funds have some advantages and disadvantages that you should be aware of before investing in them. Here are some of the pros and cons of target date funds:
Pros
- Simplicity: Target date funds are easy to use and require minimal effort from you. You only need to select a fund that matches your goal and make regular contributions. You do not need to worry about asset allocation, rebalancing, or switching funds as you age.
- Diversification: Target date funds offer a diversified portfolio that invests in various asset classes, sectors, regions, and styles. This can help you reduce the risk of losing money due to a single market event or a poor performance of a specific asset.
- Professional management: Target date funds are managed by experienced fund managers who have the expertise and resources to monitor the market and adjust the portfolio accordingly. They can also take advantage of opportunities and avoid pitfalls that you may not be aware of.
Cons
- Lack of customisation: Target date funds are based on a one-size-fits-all approach that may not suit your individual needs, preferences, and circumstances. For example, you may have a different risk tolerance, income requirement, or life expectancy than the average investor. You may also have other sources of income or assets that affect your overall portfolio. In such cases, you may be better off with a customised portfolio that reflects your unique situation.
- Performance uncertainty: Target date funds are not guaranteed to achieve your desired outcome or beat the market. The performance of target date funds depends on the skill of the fund manager, the quality of the underlying funds, and the market conditions. There may be periods when target date funds underperform other funds or fail to meet your expectations.
Example of TDFs
Vanguard offers a range of target-date funds designed to meet varying retirement goals. Let’s compare the Vanguard Target Retirement 2065 Fund (VLXVX) with the Vanguard Target Retirement 2025 Fund (VTTVX).
The Vanguard Target Retirement 2065 Fund has an expense ratio of just 0.08%. As of May 31, 2024, its portfolio allocation is notably aggressive, with 89.49% in stocks, 9.61% in bonds, and 0.90% in short-term reserves. The fund primarily invests in other Vanguard mutual funds, with significant portions allocated to the Vanguard Total Stock Market Index Fund (54%) and the Vanguard Total International Stock Index Fund (36.3%).
In contrast, the Vanguard Target Retirement 2025 Fund, also with an expense ratio of 0.08%, adopts a more conservative approach due to its imminent target date. Its allocation as of the same date stands at 52.02% in stocks and 47.08% in bonds, with a focus on stability. This fund allocates 31.5% to the Vanguard Total Stock Market Index Fund and a significant 28.8% to the Vanguard Total Bond Market II Index Fund.
While both funds share similar assets, the 2065 Fund's heavier emphasis on stocks positions it for higher growth potential, albeit with greater volatility. Conversely, the 2025 Fund is structured to support those nearing retirement, prioritising fixed-income investments to ensure stability and liquidity for withdrawals as the target date approaches.
Factors to consider when choosing a target date mutual fund
Target date funds are not all the same. They may differ in terms of their asset allocation, risk level, fees, performance, and quality. Therefore, you should not choose a target date fund based solely on its name or date. You should also consider the following factors when choosing a target date fund:
- Asset allocation: The asset allocation of a target date fund determines its risk and return potential.
- Fees: The expense ratio and turnover fees of a target date fund affect your net returns and wealth accumulation.
- Performance: The performance of a target date fund reflects its ability to achieve your goal and generate returns.
- Quality: The quality of a target date fund depends on the reputation and track record of the fund manager and the underlying funds.
How to invest in target-date funds?
Investing in target date funds is relatively easy and straightforward. You can follow these steps to invest in target date funds:
- Step 1: Determine your goal and time horizon. You should have a clear idea of what you are investing for and when you need to access your funds. For example, if you are saving for retirement, you should estimate your retirement age and expected retirement income.
- Step 2: Choose a target date fund that matches your goal and time horizon. You should select a fund that has a date close to your goal and an asset allocation that suits your risk tolerance and time horizon. You should also consider the factors mentioned above, such as fees, performance, and quality, when choosing a fund.
- Step 3: Open an account and make contributions. You should open an account with a broker, bank, or fund house that offers the target date fund you have chosen. You should then make regular contributions to the fund, either as a lump sum or as a systematic investment plan (SIP). You should also review your account periodically and adjust if necessary.
How much do target date funds cost?
The cost of target date funds depends on the fees and expenses that the fund charges. The main fee that you need to pay is the expense ratio, which is the annual fee that the fund charges as a percentage of your assets, it is charged on a daily basis. The expense ratio of target date funds in India ranges from 0.5% to 2.5%, depending on the fund house and the fund category. The expense ratio covers the fund management, administration, and distribution costs.
In addition to the expense ratio, you may also incur other costs, such as exit load, transaction costs, and taxes on returns.
Who should opt for target-date funds?
Target date funds are suitable for investors who have a long-term goal, such as retirement, and want a simple and convenient way to invest for it. They are also suitable for investors who do not have the time, knowledge, or interest to manage their own portfolio and prefer to delegate the investment decisions to a professional fund manager. These funds can help such investors achieve a diversified and balanced portfolio that matches their risk tolerance and time horizon, without requiring much effort or intervention from them.
However, target date funds are not suitable for everyone. Target date funds may not suit investors who have a short-term goal, such as buying a car or a house, or need to access their funds frequently. They may also not suit investors who have a specific or complex financial situation, such as multiple goals, income sources, or assets, or have a different risk appetite, income requirement, or life expectancy than the average investor.
If you are looking for an easy way to invest in mutual funds, visit the Bajaj Finserv Mutual Fund Platform today. With over 1,000 different fund options to choose from, you can surely find one that fits your requirements. Additionally, you can also compare the mutual fund returns of different schemes on the platform to help you make your decision easier.
