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If the idea of a mutual fund is to make investing less work, target date mutual funds are a logical progression in their development. By shifting their asset allocations over time from aggressive, equity-weighted portfolios to a more conservative, fixed-income oriented posture, target date funds are meant to offer investors a type of “autopilot” on the way to their retirement, eliminating the need to manage the transition themselves.

Any ship’s captain will tell you, though, that while autopilot can certainly be a useful tool at sea, it is no substitute for genuine navigation, and it should not be relied on to steer the boat from port to port. So it is with target date funds.

Investors inclined to the “set-it-and-forget-it” approach need to understand first how target date funds function, make informed choices when buying them, and monitor performance along the way.

Target date funds, sometimes referred to as lifecycle funds, had amassed an impressive $176 billion in assets as of April, according to Investment Company Institute data. Almost all of that has come since 2006, when the Labor Department issued a rule exempting employers from liability for losses incurred by target date funds sold to retirement fund investors as a “default” option in their 401(k) plan. Fidelity, T. Rowe Price, and Vanguard are the largest target fund managers, with about 80% of the market.

About the only thing target date funds have in common is they assume that contributions will cease once the target date is reached. Most, though not all, are set up as “funds of funds” and invest in both equity and fixed-income instruments. Important features such as the size of their initial equity allocation, how quickly that is reduced, the size of the final equity allocation, and whether the manager has discretion to change the plan, all differ from fund to fund.

Furthermore, not all funds reach their most conservative allocation in the year they target: some funds don’t reach their most conservative stance for 20 years after the target date, believing that investors will need equity-style returns (read, normally higher than fixed-income) to fund retirement without running out of money.

SEC Questions on Returns

As successful as these funds have been, a tempest surrounding target date funds erupted in 2009 in the wake of what Securities and Exchange Chairman Mary Schapiro described as “some troubling investment results” produced by the funds during the market meltdown in 2008. Schapiro said the average fund with a 2010 target date chalked up losses of 25% during the year, and that returns among the 31 funds with a 2010 target varied from a loss of 3.6% to a loss of 41%. The SEC held joint hearings with the Labor Department in June to discuss target date funds, and several bills are wending their way through Congress that address the issue.

The shock that followed steep losses stems from a generally poor understanding of target date funds among the investing public: a consumer research study conducted by Envestnet Asset Management and Behavioral Research Associations found that just 6% of respondents could accurately describe how the funds work, and many thought the funds provided a guaranteed return. Acknowledging the problem, the Investment Company Institute has developed a set of five principles regarding disclosure that funds should follow, including specifying that the target date in the fund name refers to the year in which the investor expects to retire, whether the fund assumes investors will make withdrawals gradually or all at once, what age group the fund is designed for, an illustration of the change in asset allocation over time, and a warning that the fund’s returns are not guaranteed.

The Right Purpose

With an adequate understanding of how a target date fund works and the risks involved, these funds do serve a bona fide purpose, especially for those investors who are not comfortable managing their portfolio actively. They can help to correct flawed investment strategies in which younger people invest too conservatively, and older investors too aggressively.

Just two target date funds have the highest five-star ranking from Standard and Poor’s mutual fund reports: the American Century Target 2015 Fund (BTFTX) and the DWS Target 2014 fund (KRFEX). The differences between the two are illuminating. The American Century fund (like other target funds in the American Century family) invests primarily in zero-coupon U.S. Treasury and agency debt. Holdings are chosen so that they mature close to the date the fund is targeting. These funds are liquidated near the end of the target year.

The DWS fund also invests in zero-coupon bonds, “and the balance of its assets in common stocks.” Its prospectus does not disclose what its initial and final equity allocations are, saying only that the fund readjusts its holdings such that the par value of its zero-coupon bond holdings is equivalent to the original investment in the fund, so that investors are protected from losses. According to its holdings disclosure for the period ending June 30, 3009, 87.8% of the fund’s assets were invested in zero-coupon Treasuries, and the rest in common stock. The fund’s Board of Directors may decide to “continue the operation of the fund after the Maturity Date by establishing a new Maturity Date,” according to the prospectus, without shareholder approval.

Standard and Poor’s Mutual Fund Reports awards four-star rankings to American Century Target 2010 (BTTNX) and American Century Target 2020 (BTTTX). S&P ranks funds according to their three year Sharpe Ratio, which measures the return of an asset in terms of its risk. For a fund to have a five-star rank, its three-year Sharpe ratio must be in the top 10% of its category, outperform its benchmark over the past three years, and outperform a three-month Treasury bill over the same time. If a fund in the top 10% outperforms the 3-month U.S. Treasury bill, but fails to outperform the benchmark, the fund will receive a ranking of four stars.

S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for mutual fund story topics.