Cruise Control Options for Your Portfolio
by Cathy Pareto, MBA, CFP®
Lifecycle funds are all the rage lately. And why wouldn’t they be? They’re one of the easiest and most practical tools for investors to map out their financial path up to a specific milestone, like (say) retirement. Planning for retirement can be scary, and lifecycle funds take the fear of investing out of the equation. In a nutshell, they work as follows. You throw a pile of money into a fund, then (to paraphrase a cheesy rotisserie oven infomercial I’ve seen) you “set it and forget it”. Yet, while lifecycle funds might be a fine solution for many investors who either lack the time or knowledge to design and monitor a customized plan, sophisticated investors can usually do much better.
What are they?
Lifecycle funds are known by other names, including “age-based funds”, “target-date funds”, and “target maturity funds” —the list goes on. The fund generally consists of a mixture of a cross section of stocks (including various asset classes like small cap, large cap, international, etc), bonds and cash. The fund automatically changes the mix of stocks, bonds and cash with the goal of expanding returns in the initial years and protecting principal as it reaches a long-term maturity, or target date. The further you are from your retirement date, the more money is invested in stocks and the greater the risk. The closer the fund gets to your target date, the more conservative the mix becomes. There are roughly one thousand lifecycle funds you might choose from. Providers like Vanguard, Fidelity, T.Rowe Price
and Barclays Global have all stepped into the marketplace. So, choosing the right fund might be challenging. Your job as the investor is to pick the appropriate target date and ensure that the underlying positions are something you’re comfortable with. As with any investment, risk is always a factor to consider. The rest is in the hands of the fund manager who makes all the decisions about asset allocation, diversification, and rebalancing.
Lifecycle funds, especially when contained in a 401k plan, are a great solution for plan participants. They can help eliminate the mass confusion that many employees and investors feel when faced with an overload of fund options. Having too many choices hinders the participants’ ability to build effective portfolios. Too many choices often result in over diversification, sub optimal returns, investment overlap, concentrated positions and additional costs. Retirement plan participants often lack the knowledge or experience to know the difference, and having too many choices augments the problem. Therefore, lifecycle funds help alleviate this challenge. Further, they help protect trigger happy investors that might be tempted to churn their own accounts while following ineffective market timing trends and they enable investors to diversify their investments and avoid the temptation to chasing hot stocks or sectors. A recent Manulife study, found that among 401(k) participants those who contributed to lifecycle funds between 1999 and 2003 earned better returns than those who selected their own investments.
Lifecycle funds are not for everyone and there is no “one size fits all” solution. While selecting the right fund should not be a mind numbing process, it does deserve some thought. Failure to carefully investigate the fund, its underlying securities, timetable and fees could result in an approach that you may not be comfortable with. Worse yet, it may be an approach that does not yield you the best results over time. Not every investor that shares a similar retirement date may be willing to accept the same levels of risk. So, a thorough investigation of the portfolio volatility is warranted.
Every fund family structures their lifecycle funds differently. Some tend to be more conservative than others. So, you’ll have to gauge if the fund is appropriate for your risk tolerance. Vanguard’s target-retirement funds tend to be fairly conservative in how they allocate between equities and bonds, while T. Rowe Price funds tends to be more aggressive. For example Vanguards Target Retirement 2030 fund holds 13.1% in bonds, while T.Rowe Price allocates 8.75% to fixed income.
Sample Asset Allocation Breakdowns
One of my biggest reservations regarding lifecycle funds is their allocation strategy, specifically their lack of true global diversification. Investors tend to bias domestic investments over foreign. They also tend to cluster around large and mid cap holdings mistakenly believing that “big” equals “safe”. The fact is that we are compensated for taking different types of risks in the market. Investors can engineer portfolios that deliver above global market index returns by designing a strategic portfolio tilt. Designing a portfolio that favors small and value companies around the globe over
pure market risk should deliver higher expected returns over extended periods of time. These benefits can be reliably captured by passive strategies (like index funds) that do not rely on either individual stock selection or market timing.
Many lifecycle funds fail to capture these benefits by holding to high a concentration in U.S. based securities, specifically large and mid cap companies. A sophisticated investor, whether they are self directed or have hired a competent advisor, should have far greater opportunities to maximize long term returns while successfully controlling portfolio risk.
Finally, target-date funds are often used improperly. Some investors and 401k participants allocate cash to a lifecycle fund and then add additional single mutual funds to their mix too. This creates investment overlap which can potentially increase costs and portfolio risk.
After giving important consideration to portfolio construction, risk tolerance and target dates, investors must not forget about the important issue of fees and turnover. Investors are urged to look for a low expense ratio — the annual percentage of the fund’s assets that are paid to the company to manage the fund. Additionally, look at the costs of the underlying assets within the fund. The best indication of fees can always be found in the fund prospectus, which is usually available on the web.
In summary, lifecycle funds are an excellent tool for the “hands off” investor who wants a path of least resistance. But, despite their convenience, lifecycle funds have quite a few significant drawbacks that should create some hesitation for more experienced investors. Remember, there is no “one size fits all” solution in investing. The investment decisions that you make today will forever impact how you live tomorrow. So, do your homework!