You don't hear a great deal about target date funds these days. That may change once enough holders pay closer attention to their recent account statements.
These products have become a staple of 401(k) plans, and the default for many investors who don't have the inclination, expertise, or time to pick funds themselves. Instead, they rely on this all-in-one approach, which is supposed to become more conservative as the target date itself approaches.
The last controversy with these seemingly innocuous all-in-one, set it and forget it funds happened during the 2008-2009 market meltdown. Some of the funds had much higher allocations to stocks than their owners might have imagined, and suffered greater-than-expected losses for those on the cusp of retirement. This forced some fund families to re-examine their approach, and hopefully resulted in greater investor attention as to the actual makeup of the target date funds they own.
Now, there's another issue affecting target date funds that many may not be aware of -- and it's on the fixed-income side.
The bond/cash component of a target date fund is supposed to help mitigate potential drawdowns from the stock allocation. That, however, is not happening in the current interest-rate environment, as bonds have been getting hammered. Target date funds typical orientation toward intermediate-term bonds has had a detrimental impact.
Take Vanguard Target Retirement funds as an example (but there are many others in the same boat). The Vanguard Target Retirement 2025 Fund (VTWNX) , a very low-cost fund, is down nearly 13.91% year-to-date, and 12.2% over the past year. Currently, the fund is a 50%/50% mix of stocks/bonds. The Vanguard Target Date 2065 Fund (VLXVX) , by contrast, with its much more aggressive 93%/7% mix is down 17.12% year-to-date and 14.08% over the past year. That's not a huge discrepancy in returns considering the massive difference in allocations to stock, and given the beating the stock market has taken, along with the much more aggressive nature of the latter.
The reason is that the duration (a measure of bond risk) on the bond side of the 2025 Fund is 6.71 (according to Morningstar, which is very close to the average of for 6.65 category). This is driven by the fund's 28.58% allocation to the Vanguard Total Bond Market II Index Fund (VTBNX) , which is down 9.16% year-to-date.
Keeping it simple, the rule of thumb for duration is that you multiply the change in rates by duration, and that tells you how a bond/bond funds value should react. A 1% increase in rates for a duration of 6 should result in a 6% drop, a 1% decrease in rates should have the opposite effect. What we are actually seeing, however, is that bonds are reacting more negatively than duration suggests, indicating that funds are pricing in additional rate increases.
A shorter duration bond position would have mitigated some of the negative returns target date funds are currently experiencing, but they are not designed for the short-term.
The takeaway for investors is that the notion that the bond side of a portfolio will tamp down overall portfolio losses is being put to the test in this rising interest rate environment.
This is the environment in which to consider building your own 401 (k) portfolio out of the funds offered instead of relying on target date funds, especially for those with closer retirement dates, where there is a significant allocation to bonds. That is assuming you have enough other choices in your 401(k) plans, and that they offer shorter-duration bond funds, and/or a stable value fund.
