Asset Allocation ETFs: Picking The Right Target-Date Fund

On the surface, picking the right target-date fund couldn't be easier: Simply identify the year in which you'll turn 65 and pick the fund closest to that date. Done. After all, the whole point of target-date funds is to make the allocation process easy for the end investor. Unfortunately, there's a lot more to consider when selecting the best target-date fund for you, especially considering the funds' ambitious goals.

Target-date ETFs aim to:

• Be a one-stop solution for all (or at least the core) of your long-term investments for retirement
• Allocate across different asset classes with a primary focus on the mix of stocks and bonds
• Change that allocation dynamically—and without any input from you—over time as the years go by
• Make suballocations within each asset class

The goals of these products demonstrate their place at the epicenter of your investments and hint at their underlying complexity. Target-date ETFs make crucial decisions that are otherwise made by an advisor on behalf of the investor or by the investor herself. Over the long haul, the overall allocation to equity and fixed income—the allocation to asset classes—is far more important to performance than the suballocations within these asset classes.

Glide Path

It follows then that the primary role of target-date funds is to allocate to asset classes (with the overwhelming emphasis on equity and fixed income) over the long haul. The key feature is that the allocation makes a gradual but steady shift from riskier assets (equity) when you're young to safer assets (fixed income) as you near retirement. The bedrock principle is that younger investors should participate in equity upside and have more time to recover from equity losses, and older investors need to protect their nest egg as they grow closer to living off of it.
This changing mix of equity and fixed income is called a glide path.

Competing target-date ETFs come with different glide paths. Those ETFs that allocate more to equity over time are considered to be more aggressive than those that don't. Still, all asset allocation funds ramp their equity exposure down over time.

Despite the paramount importance of the glide path, the ideal allocation over time is not an exact science even for an individual, much less for the "average" investor that the target-date fund caters to.

Suballocations

Beyond the all-important glide path, target-date funds also select the mix of actual securities within each asset class. For equity, this means setting the mix of U.S. stocks versus international, large-cap versus small-cap and more. For fixed income, it means allocating U.S. Treasurys, corporate debt and maybe even high yield or foreign debt. This mix might be dynamic too, over time.

Pros

While target-date funds replace many, if not most, of the decisions that a financial advisor might make for you, their strongest advantages lie in comparing how they act over time versus the do-it-yourself approach.

• Discipline – Target-date funds follow rules. They don't buy at the peak and sell at the trough, a common individual investor mistake.
• Execution – Target-date funds rebalance their exposure gradually year after year, while individual investors may procrastinate, avoid or forget entirely.
• Avoid Rookie Mistakes – Individual investors make basic mistakes, whether over-allocating to a handful of stocks, under-allocating to international stocks, or equally weighting among assets or subassets in the absence of a better idea. Target-date funds avoid these pitfalls.
• Lower cost – While a financial advisor should deliver the advantages above, they'll likely charge you more than a target-date ETF. Compounding math punishes higher costs in the long run and rewards lower costs.

Cons

• One size fits all? – Target-date funds are designed for the average investor, yet your needs are not likely to be average over the entirety of your investment horizon.
• Deaf to the market – The downside of cold discipline is that target-date funds have no capacity to move to cash or take other protective actions in down periods or capitalize on upswings.
• One basket – A target-date fund is a powerful and dynamic diversifier, but ultimately it's one product backed by one issuer. Will the product and its issuer really last for decades?
• Issuer bias – Target-date funds often hold ETFs inside them, which makes great sense given their top-down mandate. But does the Acme Target-Date fund only hold other Acme ETFs inside? Ideally, the target-date fund would pick each underlying ETF on its own merits.
• Dubious suballocations – It's not enough to be comfortable with the glide path. You need to buy into the allocations within asset classes. Are the allocations overly complex? Risky? Overlapping? Just plain odd?

While they align well with the low-cost, egalitarian credo of ETFs, target-date ETFs don't enjoy huge investor interest relative to the broad ETF world. To date, the ETF ecosystem has excelled at delivering the building blocks for these products, but not the products themselves. Still, investors have viable choices here, just not as many as we'd like. Find these products at the ETF.com Finder under the Asset Class: Asset Allocation; Focus: Target Date.

Next: Alternatives ETFs: Understanding VIX ETFs

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