Target-date funds hold hidden risks and conflicts of interest

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Target-date funds are sold as offering great benefits for investors, but we don’t think you should accept the sales pitch.

Target-date funds go against one of TSI Network’s cardinal rules of successful investing. That is to invest mainly in simple, plain-vanilla investments. This rule limits your choices to two main categories: stocks and bonds (or ETFs that hold those investments). By confining yourself to these two investment categories, you still have all the investment choices you need. You also avoid the hidden risks and conflicts of interest that you’ll find in more complex products.

Target-date funds are mutual funds that take advantage of the widely held view that bonds are inherently safer than stocks, so you should gradually shift your investments out of stocks and into bonds as you near retirement. Target date funds do this for you automatically.

Complexity is not a benefit

The funny thing is that the promoters of complex investments describe the features of these investments as if they were benefits, disregarding the associated negatives. This marketing approach attracts investors who want to make a quick decision. These investors tend to accept the sales pitch at face value.

It appears that a lot of investors were eager for just such a convenient investment solution. Assets invested in U.S. target-date funds have grown more than 10-fold in the past decade, from $70 billion to more than $750 billion.

Investors select a date for their target-date fund that is near the year when they plan to retire. Managers of target-date funds generally invest in a mix of stock and bond mutual funds from the company they work for. As years pass, the managers gradually reduce their stock-fund holdings and increase their holdings in bond funds, while remaining within the fund family.

Investment gains in these funds have averaged around 5% a year. That’s a modest return in view of the strong gains that U.S. stock and bond markets have enjoyed, overall, in the past decade.

When interest rates and inflation move upward, as they eventually will, bond market returns will shrink or turn into losses. This will cut into the gains (or expand the losses) on the target fund’s stock-market holdings.

Meanwhile, the investors could suffer from conflicts of interest that are settled in favour of the fund family.

For example, when target-date fund managers need to buy a new fund, research shows they tend to favour new funds, particularly those in operation for three months or less. This works in favour of the fund family, because it helps get the new fund off the ground. It works against the interests of the investors, since new funds tend to underperform comparable funds for their first three years in operation.

Also, some target-date fund managers seem to prefer moving into higher-fee funds: MERs (Management Expense Ratios) of up to 0.4% more than alternate funds. Here too, that’s good for the fund family, but bad for the fund family’s clients.

Advisors who sell complex investments defend them with offhand observations like “You could do a lot worse.” That’s true. But it glosses over the two key drawbacks of complex investment products.

First, they tie you to an investment strategy that could have hidden flaws. The strategy could work for a while, then suddenly quit working, and generate losses instead of gains.

Second, the design of a complex investment product ensures that it will expose you to conflicts of interests. The operators are bound to settle some conflicts in ways that work against your interests. You might even say these products are designed to create conflicts of interest that the operators can exploit.

That’s why we recommend sticking almost exclusively to simple, plain-vanilla stocks and bonds, and advise against investing in complex investment products. We do recommend a handful of ETFs (Exchange Traded Funds) in our Canadian Wealth Advisor newsletter, but our choices are straightforward and relatively gimmick-free.

Have you invested in target-date funds? Are you near the age where they should convert to bonds? Share your experience with us.

Pat McKeough has been one of Canada’s most respected investment advisors for over three decades. He is the founder and senior editor of TSI Network and the founder of Successful Investor Wealth Management. He is also the author of several acclaimed investment books. This article was published earlier this year and has been republished on the Hub with permission. 

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