The market for investment products is one driven by trends. In recent years, one of the most powerful trends has been decreasing investor involvement in portfolio construction decisions. At the security level, we see this trend embodied in the explosive growth of passive ETFs, which eliminate the need for active security selection.
At the asset class level, we see it in the increased use of target date funds, which allocate investor capital to asset classes according to a predetermined schedule. Target date funds can be found in approximately 65% of all 401(k) plans and account for roughly 20% of all 401(k) assets. In total, target date fund investments in the United States amounted to $1.1 trillion at the end of 2017.
Clearly, these are products that many investors find attractive, and understandably so. They provide investors with a simple, convenient way to invest for retirement at some future date. They let investors “set and forget,” adjusting asset allocations automatically without any intervention on the part of investors.
However, I believe target date funds are missing the mark when it comes to optimizing long-term returns, and investors should understand what they are giving up by owning these funds.
Target date funds are designed to provide investors with diversified portfolios whose asset allocations evolve over time to reflect an investor’s changing risk profile as he or she progresses toward retirement. As an example, a 30 year old investor who plans to retire in roughly 30 years might buy a target date 2050 fund. Given the relatively long time horizon, a target date 2050 fund would likely have a high allocation to equities and a correspondingly low allocation to fixed income at this point in time.
However, as time goes on and the investor gets nearer to retirement, the portfolio makeup would gradually change to include more fixed income and less equity exposure.
The so-called “glide path” (the planned changes in asset allocation over time) will vary across funds, such that different funds with the same target date may have materially different asset allocations at any one point in time. But all target date funds share this same basic feature of evolving asset allocations to coincide with evolving risk tolerances as investors move toward retirement.
This is a strong selling point for some investors, but it comes with a potentially significant drawback of which investors should be aware.
Academic research suggests that the best predictor of future equity returns is current valuations. This means that the returns you earn on your investments are primarily driven by the price you pay for the assets. This should not come as much of a surprise, as most of us know that buying low and selling high is a pretty good recipe for success in investing.
Some of history’s greatest investors have provided us with colorful quotes to illustrate this point. Baron Rothschild once famously quipped, “The time to buy is when there’s blood in the streets.” Similarly, Warren Buffett is quoted as saying, “Be fearful when others are greedy and greedy when others are fearful.”
Both of these quotes lead us to the same idea: buy assets when they’re undervalued, and sell them when they’re fully valued. This seems simple enough, but investors who buy target date funds are actually ignoring this time-tested strategy for long-term investing success.
Because target date funds follow a predetermined allocation glide path, they ignore asset class valuations! If a particular asset class sells off in a significant way, to the point that those assets are objectively cheap, an astute investor should want to over-allocate to that asset class, regardless of his or her strategic asset allocation, because the future returns for that asset class are likely to be outsized.
Conversely, if an asset class becomes overvalued, prudent investors should want to sell that asset class and reallocate the capital to more attractively priced assets. But target date funds don’t do this. Instead, they simply follow their allocation glide path, using time horizon as the only variable in determining asset allocation.
To illustrate this point, think back to the Financial Crisis of 2008/2009. The severe sell-off of equities that occurred during that period of time created one of the most attractive equity buying opportunities in the past 50 years. Accordingly, many value-conscious investors became highly aggressive buyers of equities, regardless of target allocations, simply because the expected returns for equities were so extraordinarily high.
Target date funds, by design, did not follow this strategy and instead hewed to their allocation glide paths, potentially leaving significant gains on the table.
Target date funds can be valuable for investors who are unwilling or unable to actively allocate capital to various asset classes according to valuations. Indeed, a target date fund is likely preferable to a stagnant asset allocation that considers neither valuations nor evolving risk tolerance.
But investors should understand the true cost of owning target date funds. Market movements can create significant opportunities and risks to which investors may respond in ways that improve their long-term performance. Target date funds are not designed to respond in such a way, which seems like a high price to pay for the relative convenience they offer.
 Target date funds do rebalance periodically, meaning that asset allocations are adjusted incrementally in response to market movement across asset classes. However, rebalancing is simply done to arrive back at the predetermined asset allocation for that point in the fund’s life cycle.