Target dates and index funds: which is better?

In the world of mutual funds, there are two broad categories: actively managed funds and passively managed (index) funds. (For more information, see: Passive and active management.)

Actively managed funds are operated by portfolio managers, who buy and sell securities within the fund to achieve the fund’s investment goals. Target date funds are various actively managed funds designed to “mature” at a specific time.

Passively managed index funds only need to buy and hold a basket of securities that meet the fund’s objectives without any investment portfolio turnover.

Both target date funds and index funds are designed to run automatically, but the question of which is better requires checking several variables. (For more information, see: Active management: is it useful to you?)

Index fund

Index funds are probably the simplest type of mutual fund available today. These funds simply buy all the securities listed in a given stock or bond index. For example, the Standard & Poor’s 500 Index Fund owns each of the 500 stocks included in the index, and each share of the fund represents an indivisible interest in each of these 500 companies. Almost all existing financial indexes have index funds available, whether they are foreign or domestic. (For more information, see: The trough of index funds.)

Target date fund

The management of the target date fund allows the securities in the fund to be distributed in an increasingly conservative way as the target date approaches. For example, a frugal savings plan—a retirement plan provided by the federal government for employees—provides five core funds ranging from conservative to aggressive, as well as several life-cycle funds that expire at 10-year intervals. The next one is in 2020. Maturity. Life cycle funds are funds that maintain the allocation of five core funds. At the time of the initial issuance, 24% of the assets were held by two bond funds, and the rest was allocated by three equity funds of five core funds. Then slowly redistribute funds every 90 days until the target date is reached. At this time, the initial distribution reversed, and 24% of the funds were subsequently distributed to three stock funds, and the remaining 76% was distributed to two bond funds. (For more information, see: Life Cycle Fund: Can it be easier?)

Most other target-date funds operate in a similar way, with initial asset allocation usually geared towards growth and gradually reallocated to stable or income-generating portfolios. These funds now have total assets of more than US$500 billion and are becoming increasingly popular in 401(k) and other employer-sponsored retirement plans. (For more information, see: Target date funds: more popular and cheaper than ever.)

Index and TD

As a broad category of funds, target dates and index funds are difficult to compare in many ways because they are different in structure and objectives. Internally, target-date funds are usually quite complex tools, while index funds are completely transparent and static in nature. Target date funds have a complete fee structure, while index funds usually charge little or no fees due to their passive management. In some cases, the target date fund may also invest in several different types of securities, including common stock and preferred stock, corporate and Treasury bonds, and other mutual funds. And because the latter fund usually aims to provide increasingly conservative returns over time, any comparison with index funds is fundamentally biased. (For more information, see: Who actually benefits from the target date fund?)

Investors wishing to compare these two funds may need to pick two specific funds and compare their performance over several different but identical time frames. But investors need to keep their goals in mind when looking at these data, because those who need to use funds at a specific time (such as when the relevant target date arrives) may not be good candidates for index funds, because the index may significantly increase before the funds are needed. decline. Those who need to liquidate their funds within a few years may have a better life in the target date fund, because as the target portfolio becomes more conservative, the odds of incurring huge losses will decrease over time. (For more information, see: 5 reasons to avoid index funds.)

Those who do not need to withdraw for at least 15 or 20 years may stand out among index funds; for example, a retirement saver in her 40s might wisely buy an index fund and hold it until she reaches 65 or 70. , Because the average annual return of the index during this period was 8% to 10%. Even if the market adjusts before retirement, she may still be out of the fund earlier than the target date because she participates in more growth in the remaining time period. (For more information, see: Can enhanced index funds bring low-risk returns?)

Bottom line

Comparing target date funds to index funds is like comparing apples to oranges. Each type of fund is designed for a different purpose, although both types of funds allow investors to increase their capital in a sense through autonomous driving. For more information about indexes and target date funds, please visit the Morningstar Inc. (MORN) website or consult your financial advisor. (For related reading, please see: Few target-date managers invest in their own funds.)

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