Target Date Funds

The subject of target date funds is brought up in Pound Foolish, the book I told you I was reading in my prior post.  Their popularity in the 401k market has exploded.  According to the book, in 2004 only 2% of Vanguard's defined contribution investors used target date funds.  By 2011 it was 42%.  That is big increase in a short amount of time.

So why are target date funds a bad idea?

First, they are typically not diversified.  The typical target date fund has a few bonds, a few small cap stocks, but is primarily a large cap (US and foreign stock) fund.  This is rather marginal diversification considering that Large US and Large Foreign stock, as asset classes, are not highly uncorrelated.

Second, they are costly.  In the book, Olen states "Fidelity's Advisor Freedom series charged investors in the fund a hefty 1.08% annually.... Oppenheimer's Life Cycle series got away with a 1.68% expense ratio."  Many fund companies load these funds with their own funds, creating a "fund of funds".  This creates often times a whole new layer of expenses that are not necessary. 

Third, investors are very confused on what they (target date funds) are actually are suppose to do!  According to a survey mentioned in the book, more than half of those surveyed believed that a target date fund's performance was guaranteed.  The SEC had similar results in one of its own surveys.  Obviously this is not the case, and these funds are no more guaranteed than any other mutual fund.