From the December 2008 issue of Wealth Manager Web • Subscribe!

STAYING ON TARGET

These are painful days for target-date funds. During the third quarter of 2008, funds with target dates ranging from 2015 to 2029 lost an average of 9.8%, compared to a decline of 8.4% for the S&P 500, according to Morningstar. For many shareholders, the underperformance is shocking. Designed for retirement savers, the target funds hold diversified portfolios of stocks and bonds. During normal downturns, the broad holdings should provide a cushion.

This year diversification offered little protection. The problem has been that many target funds hold big stakes in foreign stocks. Those have been pounded lately.

Until recently, the funds seemed to be working smoothly. During the five years ending in September, the average fund in the 2015 target category returned 4.3%, lagging the S&P 500 by about half-a-percentage point--a decent showing for funds that include a mix of stocks and bonds.

To provide some flexibility for investors, fund companies offer the target funds with varying dates such as 2015, 2020 and so on. The investor chooses a fund with a date near his retirement. As that retirement date approaches, the fund automatically rebalances, shifting away from equities and putting a heavier weighting in fixed income.

While the funds all seek to achieve retirement security, they employ a variety of strategies. Some funds take a conservative approach, keeping big allocations in bonds. Other portfolios are weighted more towards equities. To help investors make comparisons, Morningstar recently began tracking these funds. The group is divided into three categories: funds with dates from 2000-2014, 2015-2029, and 2030-plus. Morningstar made the distinction because funds with more distant target dates tend to have heavier equity allocations.

For this month's feature, we elected to focus on the 2015 category, a group suitable for many middle-aged clients. To find the best choice, Wealth Manager again turned to the eight-part screens developed by FI360, a consulting firm in Sewickley, Pa. FI360's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must surpass category medians. The expense ratio must fall below the top quartile.

The screens reduced the field from 405 contenders to 27 finalists. Top performers included Fidelity Freedom 2015, T. Rowe Price Retirement 2015, and Vantagepoint Milestone 2015. We awarded the title to American Century Livestrong 2015, which had the highest Alpha and five-year returns of any finalist.

American Century won the title by following a cautious course. Portfolio manager John Tyler currently has 52% of assets in stocks and the rest in cash and bonds. In contrast, most competitors had higher equity weightings.

Target funds with heavier doses of stocks included Vanguard Retirement 2015, with 62% of assets in equities, and T. Rowe Price 2015, with 66% of assets in stocks. At the aggressive end of the spectrum was Alliance Bernstein 2015, which had 72% of assets in stocks.

The big fixed income holdings enabled American Century to limit losses. During the third quarter of 2008, the fund lost 6.5%, outdoing the S&P by about two percentage points. "Our philosophy has been conservative because retirement savers can be skittish," says Tyler.

American Century 2015 is a fund of funds, investing in about 15 American Century funds, including specialists in investment-grade and junk bonds as well as foreign and domestic stocks. Some of the holdings are conventional funds offered to retail investors. But most of the investments are in a special class of fund shares called NT (no tobacco). Except for the absence of tobacco stocks, the NT funds closely resemble conventional American Century portfolios. American Century excluded tobacco in order to arrange an alliance for the target funds with the Lance Armstrong Foundation, which fights cancer and opposes smoking.

Tyler avoids making big bets on any one position, but he sometimes overweights a holding. Lately he has been overweighting value funds, including NT Large Company Value. He figures that value stocks are less volatile than growth issues, an important consideration during a time of erratic markets. "With the value bias, you are not giving up anything in terms of expected returns, but you may get a smoother ride," he says.

In 2006, Tyler had 5% of assets in a real estate fund. Then worried that the huge real estate rally could be peaking, he cut back the sector to about 1% of assets. The move proved well timed, helping to avoid the big real estate downturn that occurred in 2008. Now Tyler is beginning to eye real estate again. "Maybe in a year or two when the lending market recovers, we might look to boost the real estate position," he says.

While the fund has 3.5% of assets in junk bonds, most of the fixed-income positions are in investment-grade funds, including NT Diversified Bond. Tyler has 7% of assets in Treasury Inflation-Protected Securities (TIPS). These rise in value as the consumer price index climbs. "Washington is doing a lot to stimulate the economy, and that could eventually result in inflation," says Tyler.

Even if inflation does not accelerate, TIPS could still produce solid results, Tyler adds. By holding TIPS--and staying broadly diversified--Tyler hopes to protect shareholders in downturns and deliver big enough returns in bull markets so that shareholders will enjoy comfortable retirements.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.

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