Fund Commentary with Steve Schoepke

Target-Dated Funds (Part 3)

On the surface, target-dated funds seem, and are meant to be a simple and straightforward way to invest. But individual target-dated funds can differ in significant ways, making them anything but simple. The most important of these differences dictate how the portfolio manager allocates investments, and in turn, the performance and risk for shareholders.

Possibly the most visible indication of how a target-dated fund is managing your money is its "glide-path". The glide-path tells the portfolio manager and you, the allowable allocation of portfolio assets for all periods from the fund's inception to its target-date. Glide-paths typically allocate more to riskier asset classes early on, and gradually trim exposure levels as they move closer to the target-date. In practical terms this means that they are more heavily invested in equities when the target-date is many years away, and increasingly shift to fixed-income and finally money market holdings overtime. In theory, this makes sense, but in practice, as we saw last year, its does not guaranteed predictable performance results (see Part 2 of this Series for some reasons why).

It is important for investors to be comfortable with the target-dated fund's glide-path. While I cannot gauge each investor's comfort-level, there are 3 main questions to answer that will add to your comfort when investing in target-dated funds:

First, how tightly is the portfolio manager held to the glide-path? In most cases, portfolio allocations prescribed by the glide-path are designated by a range, which allows 'wiggle-room' in asset weights. I would look to see when and by how much the manager can vary from the glide-path - did the manager use this flexibility for gains last year, or was their timing off? I would also determine whether changes in the portfolio's allocations are scheduled for certain times, such as each quarter or annually, or whether they can be made (dynamically) at any time. Fund's that prescribe more passive rebalancing at set times, may restrict a manager's ability to respond to market turning points. Recently, more target-dated funds are allowing tactical buying/selling, i.e., shorter-term non-strategic repositioning. In my view, 'flexibility' generally is a plus in the hands of prudent and well-monitored managers, because it allows them to more quickly adjust to the market - some disagree. My concern with tactical trading, however, is that it increases costs and in a long-term fund could erode the benefits of buy-and-hold diversification.

Second, does the target-dated portfolio invest in the underlying mutual funds of other companies? The sales literature for target-dated funds (and fund-of-funds, in generally) purport to select only the "best-of-the-best" managers and funds to hold. To often though, that means investing only in their proprietary funds and not those of other companies. Such offering are less likely to always provide investors with the 'best', and are geared to distribute the sponsoring fund company's products.

And finally, does the manager change the underlying fund selections when their performance lags? If not, reread the previous paragraph.

In the next and last article in this series, I will describe a major risk inherent to target-dated, target risk, or simply investing in multiple-fund portfolios. This is the risk of fund exposure overlap, which was a major contributor to target-dated fund losses last year.

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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