“Target date funds have been arguably the biggest newsmaker this decade in the defined contribution business,” notes John Rekenthaler, vice president of research and new product development at Morningstar, Inc. “They have moved from being new, relatively unknown investments, to holding more than $200 billion and being the cornerstone of many DC plans.” Even with the currently volatile market environment, Rekenthaler suggests that these funds will remain popular for good reason, since they are broadly diversified and helps investors avoid the syndrome of buying high, selling low. “For example,” he says, “many 401(k) investors loaded up on aggressive, growth-style mutual funds in 1999-2000, only to suffer steep losses in the 2001-2003 technology bear market. Target maturity funds held up much better.”
With their increasing popularity, Rekenthaler suggests advisors use the following criteria when measuring target date funds:
Logic. Does the fund offer sound rationales for its asset allocation and security selection policies? Do these policies stand the test of time? They might have seemed reasonable when first created, but are they logical today given the changes in markets, and updates in financial theory?
Transparency. The fiduciary advisor to the plan sponsor who has placed the fund in front of the participant must understand how the fund is constructed and run. Of all mutual funds, target date funds require the greatest amount of transparency.
Performance. Intermediate-term risk and return (say, five years) is less important with target date funds than with other fund types, since these funds are meant to be held for the long term and rely less on a manager delivering alpha, but performance must nonetheless be monitored. Substandard performance should be evaluated according to the two prior points: examine if the logic for the fund remains sound and if all the reasons for the underperformance are fully understood.
Cost. Costs are always important when evaluating funds, but in particular for a fund that is intended as an extremely long-term offering, and that is often semi-passively managed. A target date fund should carry a lower cost structure than a typical mutual fund.