Target-date funds and index funds are popular investments, particularly for retirement portfolios, since they require little action on the part of investors. Target-date funds became particularly popular after they were approved for defined contribution 401(k) accounts. Both are seen as hands-off investments that can be put on autopilot and forgotten. Which is the better investment? Target-date funds or index funds? Here’s an overview of these two types of securities. If you are considering an investment in either one of these, be sure to take advantage of the insights of a financial advisor.
Target-Date Funds and How They Work
Target-date funds are a type of mutual fund or exchange-traded fund (ETF) that is made up of a collection of other mutual funds. They are often called a “fund of funds.” These funds were designed to simplify retirement planning by effectively offering a retirement portfolio in one investment vehicle. They offer diversification by investing in several asset classes within the fund. A target-date fund may contain a stock mutual fund along with a bond fund and an alternative investment fund or money market fund. Other mixes are also possible depending on the goals of the target-date fund. These funds try to achieve diversification by building the fund from several asset classes that have a low correlation with each other.
Target-date funds offer asset allocation within the fund to investors based on their anticipated retirement (or other) date. Funds with a long target date such as 2060 have a more aggressive mix of securities in the fund than funds with a near-term target date like 2025. The rationale is that investors in a 2060 fund have time to make up for any losses in riskier markets, usually the equity market. Funds that have a 2060 target date, for example, would have a heavier mix of stocks, sometimes as much as 90% of the fund, and a lighter mix of fixed-income securities. If the target date is near, like 2025, then the asset allocation would be heavier on the fixed-income side than the equity side. During the life of the fund, rebalancing of the asset allocations takes place yearly and becomes steadily more conservative as the years pass. The asset allocations gradually switch from a growth to an income strategy.
Ease of ownership is claim to fame of target date funds. They have a hands-off investment strategy and investors feel they can invest and put their retirement planning on autopilot. They don’t have to choose investment assets or determine how to rebalance the asset allocations within their portfolios.
There are issues investors should keep in mind. The fee structure is crucial if you want to avoid eating into profits. Some target-date funds have a management fee for the fund and the investor also has to pay an expense ratio for all the funds within the fund. Actively managed funds have higher expense ratios than passively managed funds. Funds near the end of the target date usually have lower fees than funds with a long target date. At the end of 2020, Morningstar found that the average asset-weighted expense ratio for target-date funds was 0.52%. At an expense ratio of 0.60%, investors start fleeing for more economical opportunities.
Target-date funds are and have been very popular, but that may be cooling off. About $1.7 trillion was invested in these funds in 2018. At the beginning of 2021, $1.6 trillion was invested.
Index Funds and How They Work
Index funds are either mutual funds that follow one of the many market indexes. They mirror the index they are following by tracking the performance of the securities represented by that index. Most index funds are weighted by market capitalization. That means that the largest companies in the index are more heavily weighted than the smaller companies. But, in theory, index funds do give you at least some broad market exposure.
Index funds are passively managed since they track a market index. They are designed to yield an average return since they track an index. Actively managed funds have the goal of outperforming the market. Because they are passively managed and fund managers don’t have to do the research and stock selection that funds besides index funds require, they are relatively inexpensive from an expense ratio point of view. Most index funds have an expense ratio of around 0.2%. The minimum investment in most index funds is not large. If you buy an index ETF instead of an index mutual fund, your minimum investment is the cost of one share which ranges from $50 to a few hundred.
Index funds offer other advantages. They provide diversification of your portfolio. If you invest in an index fund tracking a broad market index like the Standard and Poor’s 500, you get the diversification of your portfolio. However, an investor will end up with a large part of their investment in companies like Apple, Microsoft and Amazon since they make up such a big part of the index. If the technology sector experiences a pull-back, so will index funds that track that index.
Index funds may perform better than actively managed funds over the long run. For the five years ending December 2019, about 80% of large-cap funds underperformed the Standard and Poor’s 500. In the short term, one-third of large-cap funds beat the Standard and Poor’s 500.
Index funds are quite popular with $458 billion invested in them in 2018. Comparatively, $301 billion was invested in actively managed funds.
Comparison of Target-Date Funds vs. Index Funds
Which is better for the investor? Target-date funds or index funds? One thing is clear. Many investors prefer investment portfolios that they do not have to actively manage themselves. Most investors in target-date funds may be new to investing and they may be more risk-averse than other investors. They prefer to leave the portfolio management to fund managers rather than attempting it themselves whether in an index fund or a target-date fund.
The three most important factors in evaluating target-date vs index funds are:
- Time Horizon – A target-date fund is based on the investor’s time horizon. If your time horizon is 40 years from now, a target-date fund will develop a portfolio with an intent to grow during the early years and preserve wealth during later years. You can buy and hold a portfolio of index funds tracking different market indexes with different goals and it may perform as well as the market over the long term and perhaps better than comparable target-date funds.
- Risk tolerance – Both target-date funds and index funds try to minimize risk. Index funds track a market index and the goal is to perform as well as the index. Target-date funds try to outperform the market unless they are target-date index funds. A problem with target-date funds is that buried in some of the mutual funds in a target-date fund may be riskier securities than the investor can tolerate. Examples are stock in companies that are in the emerging market, foreign bonds or junk bonds.
- Tax efficiency – Many investors are in target-date funds because that is what their 401(k) offers. Since they are in a tax-advantaged investment, tax efficiency isn’t an issue until the target date. By the target date, the fund may be heavily invested in bonds. That isn’t a problem during the life of the fund, but after the target date, tax efficiency will decline. You can choose index funds for your portfolio and avoid some of the tax issues of target-date funds.
Pros of Target-Date Funds
- They are good for beginning investors who want to invest for retirement but don’t know how to pick investments.
- If an investor wants to invest and forget it, target-date funds might be a good idea.
- Target-date funds have low minimum investments that allow the investors instant diversification of their investment portfolios.
- Professionally managed.
Pros of Index Funds
- Index funds offer reasonably low risk and steady growth since they will perform at least as well as the market index they track.
- The funds typically have low expense ratios and no management fees due to passive management.
- Index funds offer lower taxes since very little trading occurs since they track market indexes.
- They reward long-term investors.
- They provide portfolio diversification.
Cons of Target-Date Funds
- These funds typically are built using funds from just one fund family like Fidelity or Vanguard.
- Many of these funds charge management fees. The expense ratios are considerably higher than for index funds and fees may be stacked since you may have to pay expense ratios for every fund within the fund.
- Some target-date funds stop controlling asset allocation after the target date.
- There may be hidden risks in some of the funds with the fund.
- Target-date funds don’t account for any outside retirement income you might have which will skew the asset allocation.
- Many of them underperform the market which means they, in general, underperform index funds.
Cons of Index Funds
- Investors will get an average market return without the opportunity to earn abnormal profits.
- Index funds will reflect market volatility since they track one of the market indexes.
- Index funds are not flexible by definition; they track a market index.
The Bottom Line
Investors in either type of mutual fund or ETF seek professional management, a hands-off approach and don’t want to be bothered with retirement planning. Index funds outperform most actively managed target-date funds. They are good for investors who are risk-averse and have a long time horizon. Target-date funds may be tax-advantaged, however, since they are approved for inclusion in 401(k)s. However, they require an investor to stick with one fund family. Target-date funds have been subject to much criticism since their development. Their asset allocation and investment strategy have been questioned, along with their high fees as compared to index funds.
Tips for Investing
- If you are interested in target-rate funds, you may want to use SmartAsset’s asset allocation tool in order to check out different funds and see if they conform to your investment goals.
- If you think you might want to invest in target-date funds or index funds, it might be best to talk with a financial advisor. Finding one doesn’t have to be hard. If you use SmartAsset’s financial advisor matching tool, you can find a financial advisor to your liking. If you’re ready, get started now.
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