Fund Commentary with Steve Schoepke

Target-Dated Funds - Maybe Too Good to be True, All the Time (Part 2)

How could this have happened? While many market participants asked similar questions over the last year, owners of Target-Dated Funds may have been more surprised than most. Average total returns for Lipper's 2010 Target-Dated Fund category was 3% for the 12-months ending with August 2008. (The average equity fund was down 3.1 % over the same time period.)

For longer-dated funds, the results were not much better. For example, Lipper's 2030 Target-Dated category was down -1.22% for the same one-year period. In short, "not as advertised".

There are reasons for the less than stellar result of target-dated funds. First, it should be remembered that the asset allocations of these funds are defined to meet a longer-term investment horizon - between the present and the target-date. As such, they will hold asset classes, including equities, even though prevailing market conditions would suggest that it may not be the best place to invest. This is because they are investing for a far-off future date, and not for more immediate market conditions. For example, it is not unusual to find funds with a target-date of 2020 or later to have the majority, and even as much as 70-80%, of their investments in equities.

This strategy should yield somewhat predictable results, after all, historically stock return an average of about 9% per year. Two problems, though, could derail the best-laid plans. First, if equities or any asset class held in the portfolio experiences an unusually severe and prolonged market hit, the fund may have difficulty meeting its targeted performance goal. For target-dated funds pegged to maturity dates far in the future, such performance volatility is expected smoothes-out with time. Funds with closer target-dates will have a tougher time recovering. However, even longer dated target-dated funds can face an up-hill struggle recovering value, if they have a big loss early in their term.

For instance, if a fund's target-date is 20 years off, and it has a significant loss in its first few years of existence, the arithmetic of compounding - in this case "negative" compounding - sets a lower starting-base and must carry the effects of the loss for a long time. In other words, for longer-term target-date funds, investors should hope for large gains early in the term and avoid sustained losses later as the fund moves toward the end-date. This strategy, by the way, is how target-date fund managers tend to structure their portfolios over the fund's term.

Unfortunately for investors in most target-dated funds, which generally just began operations only in the last few years, the recent market decline corresponded with the earliest years of their terms. These are also the years, when these fund's, regardless of their target-dates will hold their largest equity exposures. Bad timing for sure, but more to the point, unfulfilled expectations. In the next article in this series, we will discuss what investors should look out for in target-dated fund.

Steve A. Schoepke, Director of Research for Financial Research & Analysis Associates, a New York-based investment and mutual fund research firm.

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