Wednesday, April 18, 2007

When Target Funds Miss Their Mark

This article from CNN Money, When Target Funds Miss Their Mark, piqued my interest, but really just comes down to two caveats about target funds:

1) Cost ratios can be high, and
2) The structure of the fund can obscure your view of your holdings.

I've yet to see a really substantial argument against target funds (per se, rather than a general "funds with high costs are bad, and some target funds have high costs" kind of argument) for young, single investors. My own slight hesitation about target funds, I think, came from a sense that investing should be complicated, like the stock market won't make me money unless I have to sweat and strain and read Kiplinger's. I'm delighted to be done with that idea, and very pleased with my target funds, both of which have rebounded from the late-February hiccup nicely. My Vanguard fund (their 2050 target) has returned about 4.7% for the year to date.


Anonymous said...

I think Target Funds (especially Vanguard's) are excellent for young investors who lack the funds to properly diversify. But once you have sufficient funds I think there are some compelling reasons to get out of them. Actually, I'm at this stage now: I'm a 29 year old with about $120,000 in a Target Retirement Fund.

First, tax sensitivity. It is a lot harder to place your most tax-inefficient asset classes in tax-deferred accounts when you use a Target account. If you start investing outside of your tax-deferred accounts, this becomes tricky because the Target accounts are a mix of tax-inefficient and efficient funds.

Second, I'm pretty hesitant about the portfolio construction of most Target accounts. Even the good ones like Vanguard's and T. Rowe's make me leery. Here's why: all of them are dominated by US domestic equities. Some in excess of 80% of the portfolio. I think this is mistake because the principle of diversification requires that individual asset-class allocations rise to a level sufficient to have an impact on the portfolio but also requires that no individual asset class dominate the portfolio. In addition, some core asset classes are underrepresented or don't even appear. Few Target funds have REIT exposure or exposure to TIPS. Few have sufficient emerging markets exposure or proper exposure to foreign developed markets. In other words, they are betting too much on the US economy continuing to do well over the next 30 years. Of course, equity orientation is one of the key principles of proper portfolio constriction. But the crazy amounts of exposure to US equities is a gamble that violates the principle that asset allocation rest on the bedrock of diversification.

For more on both of these points I HIGHLY recommend reading David Swensen's "Unconventional Success." The points I've made come directly from his book. It will change the way you think about investing. And he is an authentic voice: he heads up the endowment at Yale and has had a stellar investment record over the past 20 years there. In addition, unlike many other investment gurus, you can tell that he really didn't write his book for the money. You get the sense that he has a deep sense of public ethics. Indeed, his annual salary at Yale is around $1,000,000. He could easily be making FIFTY times that running his own hedge fund. Buy, read, and digest his book. It will be one your best purchases.

I should also remark that when I say get out of them I don't mean into something worse. As Swensen puts it: "[I]ndividuals fare best by constructing equity-oriented, broadly diversified portfolios without the active management component." That last part is important. Skip the actively managed funds and go with Vanguard's low expense indices.

Good luck!

Evil Charity said...

I have a totally unrelated question for you...I've been reading your blog for awhile and admire your budgeting techniques. My husband and I are in a position where we have enough $$ to pay everything as it comes so we do and then have no idea what we're really spending our money on at the end of the month.

So, my question is...what type of software do you use to manage your budget? I've tried Quiken and Money and didn't really care for either (although Money was OK) and I'm thinking about designing my own spreadsheet. Any words of widsom to share?

Shoot me an email if you prefer...evilcharity at gmail dot com.