Hello everybody, it's Sam from Financial Samurai and in this episode I want to talk about target date funds. So what's a target date fund? First of all, it's known as a life cycle or dynamic risk or age based fund. It's often a mutual fund designed to provide a simple investment solution through a portfolio whose asset allocation mix becomes more conservative as the target date approaches.

So the target date is usually retirement, but it can be any upcoming expense such as college tuition. And that's what I did. I invested in two target date funds, one for my son and one for my daughter when they were born. So after four and a half years of investing in target date funds, I finally done a deep dive analysis.

And I did this deep dive analysis because the performance of these target date funds has been irking me for the past couple of years, at least since early 2020. So let me share why investing in target date funds in a 529 plan or retirement plan may not be the optimal move.

So let's discuss. In a bull market, investing in a target date fund is a suboptimal move. Why? Because a target date fund is a mixture of equities and fixed income. So if you compare that to an S&P 500 index in a bull market, obviously the target date fund is likely going to underperform because its bond weighting will not increase as much as its equity weighting.

So that's one. I made the mistake of investing in a target date fund in 2017. But in hindsight, I do see why I did it. And it's because I thought things were kind of frothy back in 2017. We've had every year since 2009, a bull market up 26% in 2009, 15% in 2010, 2% in 2011, 16% in 2012.

And it kept on going. In 2017, the market or the S&P 500 closed up almost 22%. So when I was thinking about funding the 529 plan, I was thinking, man, super funding $75,000 felt like a lot. So I didn't initially, but I ended up doing so throughout a five month period from about the middle of 2017 until the end of the year.

And my wife decided to fund $15,000 that year. And then the plan was to fund $15,000 a year. But by 2018, the market actually declined. So she super funded as well. But the thing is, we didn't adjust after the 2018 decline, because in 2019, and 2020 and 21, the S&P 500 has been on a tear, right?

31% in 2019, 18.4% in 2020, and over 25% so far in 2021. So in a bull market, investing in a target date fund is a real disappointment. And our fund in our son's fund in particular, which I write about has underperformed tremendously. For example, year to date through October, it was only up 10.85%.

Whereas year to date through October, the S&P 500 was up 24%. So that's almost a 13.2% underperformance. Now of course, I expected a target date fund to underperform purely an S&P 500 index, and more apples to apples comparison would be to compare it to a blended fund, right? Like a 70/30 fund, which is what the target date fund actually is 70% equity 30% fixed income.

However, I really didn't expect such a massive 14% underperformance. I mean, that's huge, especially if you have larger and larger amounts of money. Okay, besides underperforming during a bull market. The other downside to target date funds are the fees. Now I didn't really realize this until I called up Fidelity, but there are at least they offer two types of target date funds for your 529 plan.

One is like, they call it the Freedom Fund, which is an actively run target date fund with an expense ratio of 0.87%. And then they have the Fidelity index target date funds, which are passively index managed funds with an expense ratio of only 0.14%. Now 0.14% is obviously way better than paying 0.87%, especially if the actively run target date fund underperforms.

And this is what I actually thought I bought for my son. You know, back in 2017, I remember now, Fidelity rep saying, hey, we've got actively run funds and index funds. What would you like? And I think, and I thought I had invested in an actively run fund with the assumption that the fees were the same.

So before you invest in any of these target date funds, please differentiate between actively run with a higher fee and passively indexed target date funds with a much lower fee. We know from history that actively run funds underperform over a 10 year period, something like 80% of equity managers underperform over a 10 year period.

So those are bad odds. And then to boot, if you are going to pay a higher fee, you just compound those bad returns. Just think about this scenario. Let's say your 529 plan grows to $500,000 by the time your child turns 18. $500,000 times 0.87% is $4,350 a year in annual fees.

Instead, if you were able to just construct your own two to three fund portfolio with ETFs, you'd pay like a 0.09% fee because that's what Vanguard total stock market ETF has as an expense ratio. And that would be $450 a year, which is not bad at all. So this fee is very high.

It's a pretty big drag. And it's one of the reasons why these target date funds have been created. These actively run target date funds have been created. They're great moneymakers. Over time, target fund creators make more money from their clients as balances grow. Meanwhile, the fund managers don't have to generate any alpha for charging high fees.

Instead, the clients are okay with declining returns, making it even easier for the fund manager to do their jobs. Think about it. What kind of system where you have clients who are willing to pay you more and accept lower returns? I mean, that is a great business. So instead of investing in target date funds, you might want to invest in the firms that create the target date funds or better yet, you want to go and work for those firms and manage target date funds because the weightings are all preset.

I mean, you don't need to have any kind of investing acumen. You just need to follow a set glide path to the target date. Now it may seem that I'm very against target date funds due to higher fees and underperformance. However, if the S&P 500 decided to continue to go down after 2018, I'd probably be singing a much lighter tune because the target date funds would have outperformed the S&P 500 index because the fixed income portion would have done better.

So who should invest in target date funds? Well, I think there are four types of people. First, first time parents who want to get their 529 plan investing out of the way. That was us in 2017 when our son was born. I was in full on dad protection mode.

I wanted to preserve our capital and I wanted to focus on being a good parent. I remember selling our Honda Fit and buying a larger SUV. I remember selling our rental property so I could simplify life and get back more time to be a good father. And I was just more conservative because I didn't want to lose any of the capital that I had just accumulated over the years because I had someone depending on me.

Who else should invest in target date funds? Well, people who have no interest in staying on top of their investments every quarter, every six months, or every year. They've got better things to do. And I get it. I actually don't want to stay on top of my investments all this time because there's just so many other things I'd rather do.

And being an active investor is a really suboptimal use of time unless this is what you do as a profession. Three, busy professionals working in an industry other than finance and who have little knowledge about investing. Target date funds, probably a really simple and easy way to go. And then four, investors okay with frequently not beating the S&P 500 index in exchange for less volatility and more peace of mind.

Again, if you do invest in a target date fund, invest in an index target date fund with lower fees. Make sure you read the prospectus and you know what the expense ratio is because if you're paying close to a 1% expense ratio, it really is a drag, especially if returns are going to come down in the future.

We already see Vanguard, Goldman, Bank of America, all of these investment houses are predicted much lower returns in the future for stocks and bonds and even inflation. So that means that any fee is actually a much greater percentage of the overall return drag. I hope my post and this episode helps you think about what you're investing in and go through what you have been investing in.

You know, the set it and forget it mentality is pretty good because it forces you or doesn't force you, it just keeps you investing for the long term. But from a money management perspective, setting it and forgetting it is actually music to their ears, especially if you're paying higher fees.

What happens is life gets in the way. I invested in these funds in 2017 and in 2019 and I've just been busy doing other things and I don't want to think about these target date funds because that's why I invested in them so they can do what they're supposed to be doing.

But I wasn't aware about the fee structure and I wasn't aware that 30% of the funds were in international equities, which I'm not a fan of or I haven't been a fan of for the past several years because the US has been so strong and there's so much opportunity and I haven't been investing that way in my other funds.

So investing in these target date funds, I carved out a niche so that that money can be handled, but it's actually not aligned to my personal investing philosophy on the other funds that I manage. So you want to make sure that if you invest in these target date funds, it's aligned with your investing philosophy at the moment.

If you don't want to invest in a target date fund, you can invest in a digital wealth advisor. Those guys, they charge relatively low fees and they build your portfolio based on your risk tolerance and it's another low cost way to go. There are definitely good solutions. I just wouldn't put a majority of your capital in actively run funds and actively run target date funds.

Just the performance tends to be disappointing. It would be one thing if the expense ratio was the same, but they are not. Actively run funds tend to unperform and they charge more and the more money you have, the more money they take and it's just not a good feeling to pay more for underperformance.

I will leave you with this one piece of good news. It's actually just for me and that is I called Fidelity and I asked them because I wanted to rebalance what I thought was my actively run target date fund into an index fund and they actually said, "You're already in an index fund." So I am paying the 0.14% expense ratio and not the 0.87% expense ratio that I thought.

I'm just severely underperforming the S&P 500 index, which is a shame since our son still has 14 years left until he turns 18 and he can afford to take more risk. All right, everybody, even though I have missed out on probably 30,000 plus in lost profits by investing in target date funds, it's better than not investing at all.

So if you have any questions or comments about target date funds, I'd love to hear them in the comments in the post and I'll see you guys around.