My Problem With Target Dated Mutual Funds

One of my biggest pet peeves when it comes to personal finance is the debate amongst mutual funds. Tons of topics and questions are explored and it just drives me nuts how the most important factor is never weighed. I’ve seen forums, articles and posts that explore the ‘to load or not to load’ argument, then there’s the ‘active versus passive management’ debate, promptly followed by the ‘should I just follow an index fund’ deliberation.

NONE of these topics or discussions address the fundamental question that should be on our minds when looking at investments: What is going to make me the most money in the long run?

What investing is not?

To me investing is not for any money that is needed for less than 5 years. If I have money that I plan to use within a 5 year time frame then I keep it as far away from the stock market as possible. I don’t use government or corporate bonds as safe havens. If I want a safe haven I’m going to use a simple savings account through my bank. Bond prices can fluctuate just as wildly as single stocks in the short term and in the long term barely stay ahead of inflation.

 I maximize the stock market by leaving investments alone for at least 5 year time spans. I research and find historically proven mutual funds and buy and hold for (say it with me now class) at least 5 years. To me if I need cash and plan to make a purchase/live off money needed within that 5 year time span then I need it to be safe and secure in an FDIC insured savings account. I’m not even going to risk losing value in that cash beyond inflation; to me it’s simply not worth the risk. Investing in the stock market is about riding the wave of growing businesses for long term periods of time. So I follow a rule of thumb to only invest in the stock market for long term growth results, not as a safe haven.

My beef with target dated funds

From there exists a perceived hierarchy of the types of mutual funds. One that I loathe with every ounce of my being is the target dated fund. A target dated mutual fund works like this. Say I entered the work force in 2010 and was 21 years old and I planned to retire at 65. At my planned retirement age the year would be 2054. So a target dated fund person would encourage me to invest in a target dated mutual fund that has a target date close to the year 2054. Most of these target dated funds, name wise, run in 5 year increments so I would be encouraged to invest in a target dated fund with a target year of 2055. During the time I am investing in this fund, the fund itself will hold a sliding balance of assets between stocks and bonds. In 2010 the fund might hold around 80% stocks and 20% bonds, and in 2050 it would hold 80% bonds and 20% stocks. Obviously the sliding scale begins heavy with stocks and slides towards a heavier holding weight in bonds as the target date approaches. Target dated funds are low fee and have built in risk management. And that is how they sell this trash!

And it’s trash because the longer you hold bonds the lower your overall investment return becomes. From the “get-go” target dated funds hold bonds which barely stay ahead of inflation, and you hold that pathetic investment over decades, missing out on the long-term lift that comes with equities.

“But I paid a lower fee…”

Yes I may have paid a lower fee buying the target dated fund, but it’s lack of growth over decades, simply by holding bonds, makes the fee discount look like a ridiculous argument. I’ll paint an extreme example. Say you invest $10,000 in a target dated fund that returns 8% over 20 years and pay the super low target dated mutual fund fee of .002%, you would net $49,169.42

Pretty impressive right??? WRONG! With a historically proven growth mutual fund earning 12% over that same time frame AND let’s say paying fees that total out to an absurdly high 5%, you would net  $103,429.19. That is over a $50,000 difference! $50,000 is way too much to pay for low fees and perceived “safety.”

“What about a real life example?”

You want it? You got it.  Let’s use a similar scenario with two real life comparable funds.  Let’s say the year is 1992, I am 21 years old and just began working.  Let’s also say I’m ahead of the game and have $10,000 to invest and I plan to retire at 65, in 2036.  I could invest in a “trusted” name when it comes to target dated fund investing so in option 1 I go with VFORX, Vanguard Target Retirement 2040, widely considered a Vanguard Safe haven, VFORX also has a considerably low expense cost through my broker at 0.19%.  Flash forward to today, since inception this fund has averaged 4.39% average annualized returns, and after expenses paid, if I redeemed everything today that 10K would now be worth $66,429.38. 

Then there’s option 2 - a good growth stock mutual fund that meets my criteria to invest in – BPTRX, Baron Partners Retail Fund. Through my broker this fund has a higher expense cost at 2%. Since inception BPTRX has an average annualized return of 11.92% and through this superstar fund my 10K is now worth $118,301.02 – AFTER EXPENSES ARE PAID here at the end of January 2013.  Even with expenses that are 10 times higher BPTRX is the superior choice to VFORX by over $50,000 over the last 20 years.  And guess what? VFORX is only going to get more conservative in its investments as the years go on.

“But Rob, that wasn’t a fair comparison…”

You might be right.  After all, I couldn’t even start investing in VFORX until 2006. That’s right friends, target dated mutual funds not only have horrible returns, but the ones meant for you are still in diapers when you are just starting out in your career!  I want a proven winner in my portfolio, not a schmuck with mediocre returns.  But pound for pound let’s look at the last 3 years, all post the 2008 market drop.  VFORX over the last 3 years has averaged 9.06% average annualized returns, turning 10K into $13,109.88 after the same expenses are paid.  BPTRX, as it may surprise you has averaged 13.01% average annualized returns over the last 3 years, netting $14,743.21 after 3 years with a 10K investment.  So when you break it all down, there’s really no doubt about it: target dated funds suck.