What’s harder than picking a great ETF? Determining how much of it to hold.
You face both tasks if you’ve changed jobs and rolled a 401(k) into an IRA. Your basic challenge is how to allocate your savings across asset classes and their subgroups.
Target-date and target-risk ETFs can provide a useful reference for the allocation decision even if you don’t actually invest in them. Before you dismiss this idea out of hand, consider these all-too-common alternatives.
- “100 - age = equity allocation”: This rule of thumb puts a 30-year-old investor into 70 percent equities. Fine, but how do you break out that 70 percent between U.S. and global, or large-, mid- and small-cap?
- Naive Diversification: This phrase is shorthand for assigning dollars in equal amounts based on the number of available choices. For example, if choosing among large-, mid- and small-cap funds, you put a third into each. Unfortunately, this would produce a significant overweight to small-cap funds, which make up only 10 percent of the market by weight.
- Inaction: Faced with bewildering choices, a frustrated investor might avoid making any kind of decision. In our 401(k)-to-IRA example, this might result in staying the course—even if that course was chosen five years ago without much thought at the time.
So how can target-date ETFs help?
They’re designed to make the asset allocation decision for you. If that thought scares you, good. Because my simple idea here is to use one of these funds as a jumping-off point rather than as a direct investment vehicle.
Start by looking at a fund with a target date near your retirement date. Let’s choose the iShares S&P Target Date 2040 Index Fund (NYSEArca: TZV) for example. Because TZV is an ETF that holds other ETFs, its allocation is neatly laid out.
The pie chart at the top of the TZV home page shows the big picture: about 57 percent domestic stocks, 29 percent international stocks, 13 percent bonds, etc. Below that, we see a more granular breakdown of the stocks—developed and emerging, large-, mid- and small-cap. You also see the bond exposure: high-yield corporate bonds and Treasurys.
