The_Downside_Of_Target_Date_Funds
00:00:00.000 | Hello everybody, it's Sam from Financial Samurai and in this episode I want to talk about target
00:00:04.800 | date funds.
00:00:06.640 | So what's a target date fund?
00:00:08.040 | First of all, it's known as a life cycle or dynamic risk or age based fund.
00:00:13.860 | It's often a mutual fund designed to provide a simple investment solution through a portfolio
00:00:19.040 | whose asset allocation mix becomes more conservative as the target date approaches.
00:00:25.240 | So the target date is usually retirement, but it can be any upcoming expense such as
00:00:30.600 | college tuition.
00:00:32.440 | And that's what I did.
00:00:33.440 | I invested in two target date funds, one for my son and one for my daughter when they were
00:00:38.840 | born.
00:00:39.840 | So after four and a half years of investing in target date funds, I finally done a deep
00:00:44.680 | dive analysis.
00:00:46.380 | And I did this deep dive analysis because the performance of these target date funds
00:00:51.360 | has been irking me for the past couple of years, at least since early 2020.
00:00:56.280 | So let me share why investing in target date funds in a 529 plan or retirement plan may
00:01:01.440 | not be the optimal move.
00:01:04.240 | So let's discuss.
00:01:05.480 | In a bull market, investing in a target date fund is a suboptimal move.
00:01:10.400 | Why?
00:01:11.400 | Because a target date fund is a mixture of equities and fixed income.
00:01:16.440 | So if you compare that to an S&P 500 index in a bull market, obviously the target date
00:01:22.440 | fund is likely going to underperform because its bond weighting will not increase as much
00:01:28.360 | as its equity weighting.
00:01:30.080 | So that's one.
00:01:31.080 | I made the mistake of investing in a target date fund in 2017.
00:01:35.880 | But in hindsight, I do see why I did it.
00:01:39.480 | And it's because I thought things were kind of frothy back in 2017.
00:01:44.560 | We've had every year since 2009, a bull market up 26% in 2009, 15% in 2010, 2% in 2011, 16%
00:01:56.320 | in 2012.
00:01:57.800 | And it kept on going.
00:01:59.200 | In 2017, the market or the S&P 500 closed up almost 22%.
00:02:04.760 | So when I was thinking about funding the 529 plan, I was thinking, man, super funding $75,000
00:02:12.640 | felt like a lot.
00:02:13.720 | So I didn't initially, but I ended up doing so throughout a five month period from about
00:02:20.240 | the middle of 2017 until the end of the year.
00:02:23.640 | And my wife decided to fund $15,000 that year.
00:02:28.480 | And then the plan was to fund $15,000 a year.
00:02:31.380 | But by 2018, the market actually declined.
00:02:35.120 | So she super funded as well.
00:02:36.880 | But the thing is, we didn't adjust after the 2018 decline, because in 2019, and 2020 and
00:02:46.160 | 21, the S&P 500 has been on a tear, right?
00:02:49.680 | 31% in 2019, 18.4% in 2020, and over 25% so far in 2021.
00:02:57.520 | So in a bull market, investing in a target date fund is a real disappointment.
00:03:02.860 | And our fund in our son's fund in particular, which I write about has underperformed tremendously.
00:03:09.240 | For example, year to date through October, it was only up 10.85%.
00:03:15.440 | Whereas year to date through October, the S&P 500 was up 24%.
00:03:20.360 | So that's almost a 13.2% underperformance.
00:03:25.520 | Now of course, I expected a target date fund to underperform purely an S&P 500 index, and
00:03:31.680 | more apples to apples comparison would be to compare it to a blended fund, right?
00:03:36.120 | Like a 70/30 fund, which is what the target date fund actually is 70% equity 30% fixed
00:03:43.360 | income.
00:03:44.360 | However, I really didn't expect such a massive 14% underperformance.
00:03:51.000 | I mean, that's huge, especially if you have larger and larger amounts of money.
00:03:55.960 | Okay, besides underperforming during a bull market.
00:03:59.400 | The other downside to target date funds are the fees.
00:04:03.320 | Now I didn't really realize this until I called up Fidelity, but there are at least they offer
00:04:09.240 | two types of target date funds for your 529 plan.
00:04:12.520 | One is like, they call it the Freedom Fund, which is an actively run target date fund
00:04:17.800 | with an expense ratio of 0.87%.
00:04:22.520 | And then they have the Fidelity index target date funds, which are passively index managed
00:04:29.240 | funds with an expense ratio of only 0.14%.
00:04:32.600 | Now 0.14% is obviously way better than paying 0.87%, especially if the actively run target
00:04:42.120 | date fund underperforms.
00:04:44.640 | And this is what I actually thought I bought for my son.
00:04:48.040 | You know, back in 2017, I remember now, Fidelity rep saying, hey, we've got actively run funds
00:04:55.540 | and index funds.
00:04:57.600 | What would you like?
00:04:58.860 | And I think, and I thought I had invested in an actively run fund with the assumption
00:05:04.080 | that the fees were the same.
00:05:05.880 | So before you invest in any of these target date funds, please differentiate between actively
00:05:11.620 | run with a higher fee and passively indexed target date funds with a much lower fee.
00:05:19.380 | We know from history that actively run funds underperform over a 10 year period, something
00:05:26.080 | like 80% of equity managers underperform over a 10 year period.
00:05:31.560 | So those are bad odds.
00:05:33.540 | And then to boot, if you are going to pay a higher fee, you just compound those bad
00:05:38.120 | returns.
00:05:39.120 | Just think about this scenario.
00:05:40.120 | Let's say your 529 plan grows to $500,000 by the time your child turns 18.
00:05:46.600 | $500,000 times 0.87% is $4,350 a year in annual fees.
00:05:54.680 | Instead, if you were able to just construct your own two to three fund portfolio with
00:05:59.760 | ETFs, you'd pay like a 0.09% fee because that's what Vanguard total stock market ETF has as
00:06:07.680 | an expense ratio.
00:06:08.680 | And that would be $450 a year, which is not bad at all.
00:06:14.000 | So this fee is very high.
00:06:16.640 | It's a pretty big drag.
00:06:18.900 | And it's one of the reasons why these target date funds have been created.
00:06:23.580 | These actively run target date funds have been created.
00:06:26.740 | They're great moneymakers.
00:06:28.000 | Over time, target fund creators make more money from their clients as balances grow.
00:06:33.160 | Meanwhile, the fund managers don't have to generate any alpha for charging high fees.
00:06:39.160 | Instead, the clients are okay with declining returns, making it even easier for the fund
00:06:44.960 | manager to do their jobs.
00:06:46.600 | Think about it.
00:06:47.600 | What kind of system where you have clients who are willing to pay you more and accept
00:06:53.400 | lower returns?
00:06:55.000 | I mean, that is a great business.
00:06:57.600 | So instead of investing in target date funds, you might want to invest in the firms that
00:07:03.080 | create the target date funds or better yet, you want to go and work for those firms and
00:07:08.760 | manage target date funds because the weightings are all preset.
00:07:13.120 | I mean, you don't need to have any kind of investing acumen.
00:07:16.920 | You just need to follow a set glide path to the target date.
00:07:21.600 | Now it may seem that I'm very against target date funds due to higher fees and underperformance.
00:07:27.680 | However, if the S&P 500 decided to continue to go down after 2018, I'd probably be singing
00:07:34.920 | a much lighter tune because the target date funds would have outperformed the S&P 500
00:07:40.000 | index because the fixed income portion would have done better.
00:07:43.760 | So who should invest in target date funds?
00:07:46.560 | Well, I think there are four types of people.
00:07:49.440 | First, first time parents who want to get their 529 plan investing out of the way.
00:07:54.520 | That was us in 2017 when our son was born.
00:07:57.600 | I was in full on dad protection mode.
00:07:59.880 | I wanted to preserve our capital and I wanted to focus on being a good parent.
00:08:04.440 | I remember selling our Honda Fit and buying a larger SUV.
00:08:08.200 | I remember selling our rental property so I could simplify life and get back more time
00:08:13.240 | to be a good father.
00:08:15.160 | And I was just more conservative because I didn't want to lose any of the capital that
00:08:19.600 | I had just accumulated over the years because I had someone depending on me.
00:08:25.080 | Who else should invest in target date funds?
00:08:27.120 | Well, people who have no interest in staying on top of their investments every quarter,
00:08:32.400 | every six months, or every year.
00:08:34.880 | They've got better things to do.
00:08:36.640 | And I get it.
00:08:37.640 | I actually don't want to stay on top of my investments all this time because there's
00:08:42.320 | just so many other things I'd rather do.
00:08:45.200 | And being an active investor is a really suboptimal use of time unless this is what you do as
00:08:51.440 | a profession.
00:08:52.760 | Three, busy professionals working in an industry other than finance and who have little knowledge
00:08:58.040 | about investing.
00:08:59.760 | Target date funds, probably a really simple and easy way to go.
00:09:03.680 | And then four, investors okay with frequently not beating the S&P 500 index in exchange
00:09:09.480 | for less volatility and more peace of mind.
00:09:13.120 | Again, if you do invest in a target date fund, invest in an index target date fund with lower
00:09:19.600 | fees.
00:09:20.600 | Make sure you read the prospectus and you know what the expense ratio is because if
00:09:26.080 | you're paying close to a 1% expense ratio, it really is a drag, especially if returns
00:09:32.080 | are going to come down in the future.
00:09:34.280 | We already see Vanguard, Goldman, Bank of America, all of these investment houses are
00:09:39.360 | predicted much lower returns in the future for stocks and bonds and even inflation.
00:09:44.860 | So that means that any fee is actually a much greater percentage of the overall return drag.
00:09:52.420 | I hope my post and this episode helps you think about what you're investing in and go
00:09:58.260 | through what you have been investing in.
00:10:01.320 | You know, the set it and forget it mentality is pretty good because it forces you or doesn't
00:10:06.320 | force you, it just keeps you investing for the long term.
00:10:09.640 | But from a money management perspective, setting it and forgetting it is actually music to
00:10:14.280 | their ears, especially if you're paying higher fees.
00:10:17.640 | What happens is life gets in the way.
00:10:20.000 | I invested in these funds in 2017 and in 2019 and I've just been busy doing other things
00:10:26.500 | and I don't want to think about these target date funds because that's why I invested in
00:10:30.840 | them so they can do what they're supposed to be doing.
00:10:34.240 | But I wasn't aware about the fee structure and I wasn't aware that 30% of the funds were
00:10:39.440 | in international equities, which I'm not a fan of or I haven't been a fan of for the
00:10:44.080 | past several years because the US has been so strong and there's so much opportunity
00:10:49.000 | and I haven't been investing that way in my other funds.
00:10:52.480 | So investing in these target date funds, I carved out a niche so that that money can
00:10:57.600 | be handled, but it's actually not aligned to my personal investing philosophy on the
00:11:04.120 | other funds that I manage.
00:11:06.100 | So you want to make sure that if you invest in these target date funds, it's aligned with
00:11:10.640 | your investing philosophy at the moment.
00:11:13.780 | If you don't want to invest in a target date fund, you can invest in a digital wealth advisor.
00:11:19.420 | Those guys, they charge relatively low fees and they build your portfolio based on your
00:11:24.680 | risk tolerance and it's another low cost way to go.
00:11:28.240 | There are definitely good solutions.
00:11:30.000 | I just wouldn't put a majority of your capital in actively run funds and actively run target
00:11:36.360 | date funds.
00:11:37.840 | Just the performance tends to be disappointing.
00:11:40.320 | It would be one thing if the expense ratio was the same, but they are not.
00:11:45.360 | Actively run funds tend to unperform and they charge more and the more money you have, the
00:11:51.080 | more money they take and it's just not a good feeling to pay more for underperformance.
00:11:56.520 | I will leave you with this one piece of good news.
00:11:58.800 | It's actually just for me and that is I called Fidelity and I asked them because I wanted
00:12:02.520 | to rebalance what I thought was my actively run target date fund into an index fund and
00:12:07.520 | they actually said, "You're already in an index fund."
00:12:10.880 | So I am paying the 0.14% expense ratio and not the 0.87% expense ratio that I thought.
00:12:18.040 | I'm just severely underperforming the S&P 500 index, which is a shame since our son
00:12:23.760 | still has 14 years left until he turns 18 and he can afford to take more risk.
00:12:29.320 | All right, everybody, even though I have missed out on probably 30,000 plus in lost profits
00:12:35.280 | by investing in target date funds, it's better than not investing at all.
00:12:39.240 | So if you have any questions or comments about target date funds, I'd love to hear them in
00:12:43.560 | the comments in the post and I'll see you guys around.