Index funds and target date funds: what is the difference?

Index Funds and Target Date Funds: Overview

Choosing index funds and target date funds in a 401(k) is a common dilemma. The main factors in making this choice are the investors’ knowledge of the financial markets and how much time they want to spend. Target date funds provide easy-to-understand options, which are quite effective for most investors. For target date funds, all investors need to know when they will retire. Index funds allow people to invest directly in different asset classes, which usually saves costs and allows them to better control risks and returns.

Index funds usually reflect the performance of stock or bond indexes at a lower cost. The expense ratio of US stock and bond index funds is usually equal to or lower than 0.1%, while the expense ratio of international assets can be lower than 0.2%. However, investors can only rely on themselves. They must combine these assets in a way that minimizes risk for a given level of expected return. This is great, as long as you are interested in modern portfolio theory (MPT).

Target date funds can use managed funds and index funds to create investment portfolios that professional managers consider suitable for investors. As the target date approaches, managers will reduce the allocation of risky assets such as international stocks, and increase the proportion of funds dedicated to less volatile assets such as bonds. Most of the best target date funds have an expense ratio of less than 1%, and some are even less than 0.1%. Generally, target-date funds that invest in index funds tend to have lower fees.

Key points

  • Index funds provide more choices and lower costs, while target date funds are a simple way to invest in retirement without worrying about asset allocation.
  • Index funds include passively managed exchange-traded funds (ETFs) and mutual funds that track specific indexes.
  • Investors can combine index funds on their own to achieve similar performance to target-date funds and reduce fees in the process.
  • The target date fund is actively managed and reorganized regularly to gradually reduce risks as the target retirement date approaches.
  • The risk of target date funds may be greater than most people expect, but as the target date approaches, their volatility is usually lower than that of individual stock market index funds.

Index fund

Index funds are very popular among individual investors and financial professionals. They include exchange-traded funds (ETF) and mutual funds, which are designed to track specific indexes, such as the S&P 500, Russell 2000, or EAFE. Index funds provide broad market exposure and low operating expenses.

Index funds cover domestic and international stock and bond investment styles. Others may track obscure indexes or exotic asset classes, such as Brazilian small-cap stocks. However, these types of index funds rarely appear in 401(k) plans.

Standard & Poor’s 500 Index Funds, International Stock Index Funds and Bond Index Funds provide sufficient varieties as the core of a diversified investment portfolio. Other useful combinations include small-cap stocks, mid-cap stocks, emerging market stocks, and perhaps real estate investment trusts (REITs). By accessing these asset classes, investors can use index funds to quickly build a diversified investment portfolio for themselves and save money.

Like any other investment, index funds are also risky. In addition, any setbacks that affect benchmarks will appear in index funds. If you are looking for flexibility, then index funds will not be able to meet your needs, especially in response to falling prices of index securities. You must change the asset allocation yourself by investing in different index funds.

Although most index funds have low costs, some index funds have high prices. For example, the expense ratio of Rydex S&P 500 Fund (RYSOX) is 1.68%.This is shocking when you consider the fact that funds holding the same assets generally charge less than 0.05%. High-cost index funds are a special issue in 401(k) plans that mainly include managed funds, so be sure to check the fees.

Target date fund

If your company offers a target date fund, it is worth considering. You can invest all 401(k) accounts in the appropriate target date fund, or you can choose to invest from the full lineup of the plan.

They are called target date funds because the assets will be reorganized at a certain date in the future to meet the needs of investors. Mutual fund companies often name the fund after the target year. The idea is that investors will need this money that year, usually for retirement purposes. Investors do not have to choose a series of investments, but can choose a target date fund to achieve their retirement goals.

Many 401(k) plans have target date funds. However, corporate plans usually only provide access to target-date retirement funds from a single provider. Fidelity, Vanguard and T. Rowe Price are popular choices. All three use their own funds as their basic investment. Other companies may offer different strategies, such as exchange-traded funds (ETF) funds.

The level of risk that seems appropriate to a fund manager may not be suitable for your life. Check the performance of the fund on the target date in 2008 and early 2020 to see if a fund is too risky.

Some investors mistakenly believe that the risk of target-date funds is always lower than that of S&P 500 index funds. This is not necessarily true. These funds sometimes first invest heavily in risky assets such as emerging markets and small-cap stocks in order to increase long-term returns. As the fund approaches its target date, fund managers will regularly redistribute holdings and reduce risks.

After a similar incident occurred in 2008, the target date fund suffered another major loss in 2020. For example, the T. Rowe Target Price 2025 Fund (TRRVX) lost more than 20% during the market crash in 2020.For some investors who are only five years away from retirement, this loss may seem excessive. Transferring some assets to government bond ETFs is an easy way to reduce overall risk (and expected returns).

special attention items

Actively managed mutual funds such as target date funds have received bad reviews. In many cases, this is well deserved. However, not all actively managed funds are bad investment choices. For example, Vanguard’s Wellington Fund combines reasonable fees with strong performance for nearly a century.Many other managed funds also provide consistent returns, proven investment strategies and reasonable expense ratios. The real competition is not between index funds and target date funds. Instead, investors must choose to invest their savings in a single target date fund or several separate funds, which may be index funds or managed funds.

It is best to consider asset allocation for those who follow this path. If the 401(k) plan is the only investment, then this account is the only one that needs to be considered. Many people have other investment accounts, such as an individual retirement account (IRA), a spouse’s workplace retirement plan, or taxable investments. In this case, the 401(k) plan allocation is only part of the overall investment portfolio.

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