Become a better investor
Lesson in Course: ETFs and mutual funds (advanced, 8min )
There are simple investments we can use for retirement. What are they, and how do they work?
The lesson on creating investment goals reminds us that well-defined investment goals are time-bound. This concept marks the time when we'll need to use the money from our investments to pay for these goals.
Professional investment managers used this concept to create target-date funds. These are mutual funds or ETFs that use a predetermined time horizon to shape the investment strategy.
We often use target-date funds as a simple investment vehicle for long-term investment goals like retirement or saving for a child's college education.
Target-date fund managers name these funds by the year the investor will need cash, so they will use the time horizon to create a portfolio and consider the risks on our behalf.
For example, Vanguard, a popular investment manager, launched Vanguard Target Retirement 2065 funds. These funds are for anyone planning to retire in 2065 and gives the portfolio managers a timeline for growing the investments. In 2065, the fund doesn't dissolve; instead, the portfolio manager implements a reasonably safe strategy and stops actively managing the fund.
Longer time horizons allow us to take more risk, but the investments in target-date funds change over time.
Following the initial launch, a target-date fund starts with an aggressive portfolio, invested mainly in stocks. The fund manager tries to maximize returns early on since there's enough time to make up for any downturns. As the fund approaches the target date, the fund manager adjusts the portfolio to be more conservative. They want to lower risk by investing more in bonds and holding cash.
Every year, the portfolio managers reassess and reset the allocation of investment categories to decrease the risk slowly. Many managers call this a glide path and will visualize the changes in risk over time.
Target-date funds provide several benefits:
As convenient as target-date funds are, there are tradeoffs:
Selecting a target-date fund can be very straightforward, with a few criteria to consider:
Most people retire at age 65.
We should pick a target-date fund that matches the year we turn 65 or coincides with our retirement goal. While that's the most popular way of selecting a target date, we can skew towards more or less risk.
For example, if we want lower risk, we can pick a Target Retirement 2055 fund even if we turn 65 in 2065, or go with a Target Retirement 2070 fund to take more risk.
A lower expense ratio means paying less in fees.
Expense ratios differ between target-date funds based on the manager and strategy. Actively managed target funds are more expensive than passively managed funds or ETF-based target funds.
For instance, let's compare Fidelity's 2060 index fund (FDKLX) to the 2060 fund (FDKVX). FDKVX charges an expense ratio of 0.75% or more than six times the cost of FDKLX. Over time, the cost of this fee compounds and adds up.
The investment performance will tell us if the portfolio manager is worth the fee.
Some target-date funds have been around for less than 10 years; however, we can sense the portfolio manager's performance if the average 5-year return is available.
In the example of both Fidelity 2060 funds above, the average 5-year return of FDKVX is higher, tempting us to think it's a better choice. However, it charges six times more in fees. When subtracting out the expense ratio, the returns are comparable.
The expense ratios are fixed every year, regardless of the returns. Higher fees don't guarantee higher returns and can even cause our actual returns to be worse than lower-fee funds.
The most popular target-date funds are those managed by large financial institutions. These funds show stability and provide us with a long-term view of the talent these firms hire. Below is a list of popular managers for target-date funds.
Target-date funds are beginner-friendly financial products that provide the benefit of a managed account without paying the higher fees charged for custom investment advice. The funds are flexible and useful for goals with different time horizons.
For example, we might have a few different goals and not much time to manage our investments. We can choose a few target dates that match our goals, investing money every month into those funds.
If we have a 401(k), we probably have access to target-date funds. However, the choices provided between funds by different managers are limited depending on the 401(k) administrator and provider. We can roll our 401(k) into an IRA when we change jobs or open a brokerage account for more choices of fund managers at Fidelity, T Rowe Price, or Vanguard.
Mutual funds or ETFs provided by professional investment managers that use a predetermined time horizon to shape the investment strategy, targeting life goals in the future.