Target date funds (TDFs) were first created in the 1990s and have proved to be hugely successful in the US, with more than $700bn (£457bn) invested in them at the end of 2014 according to research from Morningstar. We are now starting to see this trend take hold on this side of the Atlantic.
The target date
TDFs are diversified multi-asset funds where savers are required to decide only the amount they wish to invest and the “target date” when they expect to begin making withdrawals for a future goal.
The target date is the time at which the investor will expect to begin withdrawing their money. The unique characteristic of a TDF is that the fund manager adjusts the asset allocation depending on the closeness to the target date. The portfolio gradually reduces in risk over time as the investor changes from having a growth objective at the beginning towards a withdrawal objective at the target date. The growth objective requires a higher risk-return strategy – the withdrawal objective requires a lower risk-return strategy. TDFs gradually transition from one to the other on approach to the target date which is the ‘turning point’ between the two. This is a common sense investment approach but conveniently delivered within a single fund.
Risk, return and time
Deciphering how much risk/return potential to have in a portfolio is a key decision for any investment strategy. Cash is a safe asset in the short run but a risky asset in the long-term because of inflation. Bonds and equities have a higher return potential, but that comes with a higher level of short-term risk because of volatility. Over the long-term, their ability to beat inflation means they are an essential ingredient to an investment portfolio.
Traditionally, savers needed to choose a level of risk in a portfolio that is right for them, bearing in mind that what’s right for them will change over time. Sometimes this is done by working out an individual’s general attitude towards risk that considers how much risk feels “comfortable”. The reality is that few people like any risk at all, so attitude to risk is not necessarily aligned with the risk-return profile needed to achieve their investment goals.
TDFs take a different approach and consider risk profile as defined by time horizon. This is known as “risk capacity” – how much risk-return potential is required to achieve an investment goal over time. When time horizons are long, risk capacity – the ability to benefit from risk to provide returns – is high. When time horizons are short, risk capacity is low, as expected withdrawals become imminent.
A diversified portfolio across assets types and geographies
The investment portfolio represents a changing mix of all the major asset classes – UK and global equities, emerging markets, property, UK and global corporate bonds, and government bonds, which together represent thousands of underlying securities. Conveniently as these are all held within a single fund, it’s easy to keep an eye on performance of the portfolio as a whole.
By using a TDF, savers can get professional help to manage the complex asset allocation decisions required for an investment strategy over time. This leaves savers with a sense of safety and protection – they can sleep at night knowing that a manager is monitoring their fund towards the target date and navigating it through the changing market and economic environment.
Making it easier
TDFs remove a lot of the stress of designing, managing and sticking to a diversified investment strategy to achieve a goal in the future. If the date of the goal changes, savers can switch to a different TDF, and like any other multi-asset fund, savers can top-up, or take out money at any time without penalty.
TDFs are therefore particularly good for inexperienced or time-poor savers who are looking to build a pot for a particular future goal, or as a core portfolio for more confident savers. There is no requirement for the investor to decide which funds, or combination of funds, to invest in from the thousands that are available. They simply choose one fund that is purposely designed to help them potentially achieve their goal, for example, providing for their retirement, building up a deposit for a house, or paying off a student loan. The TDF manager is then able to manage the balance between risk and return based on the remaining time horizon to the target date.
Avoiding common mistakes
By having a professionally managed portfolio over time, savers using TDFs are less prone to ‘behavioural biases’ that can damage long-term returns. Examples of these behavioural pitfalls that most savers can suffer include:
–chasing winning stocks or funds whose performance may subsequently decline,
–chasing star managers who are rarely able to maintain their record,
–holding on too long to poorly performing stocks or funds in the hope they might bounce back,
–allowing appetite for risk to be dictated by current market circumstances,
–not managing the investment mix of their portfolio over time because changing it requires too much hassle and thought.
The biggest behavioural pitfall of all is leaving money in cash because investment is simply too complicated. By using TDFs, you have a professional on your side to help make asset allocation decisions based on the time horizon to your goal and based on the changing market conditions.
Economies of scale
From an administrative point of view, having one fund that holds a managed portfolio as opposed to a ‘pick and mix’ of different funds whose weights need to be rebalanced or altered over time results in a lower management cost for TDFs. Additionally, since savers can share similar time horizons for their respective goals, there are economies of scale that reduce trading costs as well as increasing efficiency and convenience. This also ensures that the fund manager of each TDF has a daily oversight of the fund’s strategy, and has the flexibility to make changes to the fund’s asset allocation to adapt to market changes across the entire suite of funds for all target dates. This means there is a high level of risk management, fiduciary-style oversight and sensitivity to an economy that is constantly changing.
Opportunities
TDFs provide savers with the opportunity to invest their money in a diversified multi-asset fund that is managed over time to help meet their needs and goals, without many of the worries that traditionally accompany more complicated investment decisions – their benefits as an easier approach to professional investing are undeniable.
James Priday is founder and managing director of Strawberry Invest
