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When you’re trying to pick out which funds you want to invest in through your retirement accounts, you’ll most likely notice that two types in particular have received a lot of buzz: target-date funds and index funds.
When I first got into investing back in the early 2000s, I remember reading some of the popular magazines at the time and they were going nuts about target-date funds. They were being hailed as this grand solution for people who were new to investing or just wanted a simple way to prepare for retirement.
But a few years later, I started noticing another kind of fund being praised in both books and personal finance blogs alike: the index fund. This was another wildly simplistic option that supposedly outperformed almost all other funds on the market.
Today, both types of funds are offered by nearly every broker and workplace retirement plan provider you can think of. But with only so much money to invest, how does the average person know which one they should be pouring their money into?
In this post, we’ll explore the differences between target-date funds and index funds. We’ll go over the pros and cons of both, and ultimately which one is better suited for your investment goals.
What is a Target-date Fund?
A target-date fund is designed to be an all-in-one solution for retirement. You (the investor) pick the fund with the year that most closely resembles the year that you’d like to retire (example: 2040, 2045, etc.). Behind the scenes, the fund manager makes constant adjustments to its composition to ensure that your investment becomes more stable as you get closer to retirement.
Target-date funds are sometimes also called life-cycle funds or age-based funds. In terms of long-term investing, they’re often hailed as a true “set it and forget it” solution for the average saver.
How Do Target-date Funds Work?
Let’s say you were going to retire in roughly 30 years. The conventional thing to do would be to buy a mixture of funds containing stocks, bonds, and other types of assets.
The proportion that you’d devote to each of these categories would be called your asset allocation. For example, if you had a portfolio with 90 percent stocks and 10 percent bonds, then you’d have a relatively aggressive asset allocation.
Generally speaking, when you’re young, an aggressive asset allocation is what the experts recommend you should have. This is because of the higher risk, you’ll take advantage of the higher potential for rewards.
Even if the markets were to dip and you lost money some years, you’ve got a much greater chance that you’d make it back thanks to your long investment time horizon.
Now, what happens as time goes on? As you approach your retirement target date (20 years, 10 years, 5 years, etc.), the experts recommend that you should dial down your asset allocation from risky investments to more stable ones.
For instance, you might tweak that 90/10 asset allocation to a 60/40 or even 50/50 stocks to bond ratio.
How do you know which proportion is correct? The old rule of thumb is to take your age and subtract it from 110 to get the amount that should be invested in stocks. The rest should go to bonds.
For example, I’m 40 years old. So according to the rule of 110:
- 110 – 40 = 70 percent of my portfolio should be invested in stocks
- The remaining 30 percent of my portfolio should be invested in bonds
(FYI – There are other variations of this rule. Some say to use 120 so that you’ll be more aggressively weighted in stocks. Others say to use 100 so that your portfolio will be more conservative.)
Since your age changes every year, the idea is that your asset allocation should also be changing too. Logging in and shifting them every 3 to 5 years would be sufficient.
Admittedly, unless you’re very hands-on when it comes to investing, then this can seem like a real chore. You could have a financial advisor to do it for you, but then that means you’ll also have to pay them a fee each year.
This is the beauty behind a target-date fund. With a target-date fund, the fund manager will gradually change the asset allocation for you as you approach your retirement date. All you have to do is invest and the fund literally does all of the work for you.
Depending on the provider of the target-date fund, this could be done in one of two ways. Sometimes there is an active fund manager, a real person who decides which assets to invest and when the transitions should occur.
Other times target-date funds are more passive in nature and rely on computer models to automatically shift their asset proportions. Either method accomplishes the same goal.
What's the History Behind Target-date Funds?
Back when I first got into investing in the early 2000s, target-date funds were a relatively new type of investment product. They had only been created a few years earlier in the 1990s.
Target-date funds were the brainchild of two investment advisors from Barclays Global Investors: Donald Luskin and Larry Tint. The financial industry loved this idea and nearly every brokerage around came up with their own version of a target-date fund.
Their popularity grew even more so when 401k plans started including them as the “easy option” for savers who were confused about which types of funds to pick.
I’ve had many colleagues over the years tell me that they went with a target-date fund to avoid the hassle of trying to figure out which fund was better than the next.
This point was only further reinforced when the government started allowing employers to automatically enroll their workers into 401k plans as part of the 2006 Pension Protection Act. For the majority of these employees, their contributions defaulted into a target-date fund.
What are the Pros to Target-date Funds?
There’s a lot to like about target-date funds. Here are some of the benefits to investing in one:
Automatic Asset Allocation Management
Like I described earlier, this “do it for me” reallocation of your investments is really the appeal of a target-date fund. Rather than having to remember to log in to your account and shift your funds around every few years, you can rely on the fund itself to do the job for you.
In theory, you shouldn’t have to lift a finger until you retire. In fact, even after retirement, many of these funds switch from a capital appreciation strategy to an income maximization strategy. So the benefits continue!
The other great thing about target-date funds is that they put you in a position where you’re reasonably diversified across dozens of asset categories. Doing this on your own can sometimes be a challenge for new investors.
I had this problem when I was first picking out which funds I wanted for my 401k. I remember scratching my head thinking: Do I want large, medium, or small-cap stocks? Growth or value? Government or corporate bonds? … and what are international equities?
With a target-date fund, you don’t have to worry about these kinds of questions. The fund takes care of all those decisions for you.
If you’re someone who’d rather take a hands-off approach to invest, then target-date funds are the answer. In one purchase you can get a reasonably constructed portfolio that will automatically transition on its own without your involvement.
I’ve heard of some people paying their financial advisors a fee of up to 1.0 percent of their investment just to manage this same type of function for them. With $500,000, that’s a cost of $5,000 per year. How ridiculous is that when they could just use a target-date fund to do virtually the same thing!
What are the Cons to Target-date Funds?
While there’s a lot to like about target-date funds, they’re not without their criticisms. Here are a few important things to remember before you invest your money.
When I had my old 401k, I remember they had target-date funds as an option. However, I steered clear of them for one very important reason: They were expensive!
The target funds in my company plan were charging close to a 1.0 percent expense ratio. And that’s not just a fluke. According to the Investment Company Institute, these fees can range anywhere from 0.1 percent to as high as 1.5 percent with an average of 0.51 percent.
Frankly, when compared to low-cost brokers like Vanguard and Fidelity, that’s way too high. You can easily shop around and find other reasonably priced mutual funds in the 0.25 percent neighborhood.
All of this talk about expense fees being fractions of a percentage might seem insignificant. But when we’re talking about hundreds of thousands or even millions of dollars, it will definitely make an impact on your bottom line.
Consider this hypothetical example. Suppose you invest $100,000 into two funds:
- Investment A with an expense ratio of 1.25 percent.
- Investment B with an expense ratio of 0.25 percent.
Though that’s only a difference of 1.0 percent, after 30 years of compound growth, you’d have a net balance as follows:
- Investment A = $709,637
- Investment B = $938,681
Yes, those fees really did erode $229,044 from the portfolio. That’s not something I’d take lightly!
Another reason some people prefer to shy away from target-date funds is because of lackluster performance.
For example, if I look up the Fidelity Freedom 2030 Fund (FFFEX), I can see that over the last 10 years it’s had an average return of 9.28 percent. However, that’s not as great as the S&P 500 stock market index which has produced a 10-year average return of 14.84 percent for the same time period.
Granted, that’s not really a fair comparison considering the Fidelity fund is currently composed of roughly 65 / 35 percent stocks / bonds whereas the S&P 500 is 100 percent stocks. By design, the target-date fund is doing exactly what it’s supposed to be doing – shifting away from higher-risk assets towards more stable ones.
But that’s just the issue. More seasoned investors might have an alternative approach or preference for staying investing in equities longer.
This is the danger of being hands-off – you lose the flexibility to adjust your asset allocation and potentially capitalize on those higher gains opportunities.
On the surface, it might sound like a target date consists of a team of investment geniuses working around the clock to determine which funds will give you the best possible return by the time you’re ready to retire. But the reality is usually quite different.
In truth, a lot of target-date funds are really nothing more than just a generic bundle of other funds or ETFs (exchange-traded funds) from the same company.
As an example, the Vanguard Target Retirement 2055 Fund (VFFVX) is just 5 of their “Total Market” branded index funds, each investing in literally every stock and bond you can think of. Essentially, it’s just a one-stop-shop to buy the whole market.
Again, that’s great for someone who wants to be hands-off. But nothing is stopping you from purchasing those same funds yourself and tweaking the asset allocation to your optimum risk vs reward level.
How Do You Invest in a Target-date Fund?
You don’t have to try too hard to find a target-date fund. Nearly every major broker has some version of a target-date fund. Just go to their website, search funds with the keyword “target”, and then you’ll get multiple options; each with a specific retirement year.
To get the most bang for your buck, the smartest place to put these funds offered by the brokerages is in your IRA. You can pick a traditional IRA to take advantage of the tax benefits now, or use a Roth IRA to pay zero taxes in the future.
Most workplace retirement plans (401k, 403b, 457) also offer them. But this will be case-by-case as each company’s retirement plan can be different. Check the plan investment offering list to know for sure.
What is an Index Fund?
Chances are that if you read blogs or look at social media related to personal finance, then you’ve heard someone talk about index funds. By definition, an index fund is a collection of securities that mirrors a market “index”.
What’s an index? In the world of finance, an index is a group of companies or assets that’s used to represent the market as a whole.
Probably the most well-known index is the Dow Jones Industrial Average. You’ll hear news reporters talk about this every evening when they say something like “The Dow was up 100 points …”. It’s how they let the public know if the stock market went up or down.
The origin of the Dow Jones dates back to 1884 with businessman Charles Dow and his colleague Edward Jones. At the time, there was no real way to track the change in the price of every publicly-traded company.
Dow and Jones cleverly decided they would track just 11 of the most prominent companies at the time (nine railroads and two industrial companies) to serve as a statistical representation for the whole market. The idea caught on, and it was later expanded in 1896 to include the 30 top-performing U.S. industrial companies.
Today, you can find lots of other stock market indices. For investors, one of the most widely used is the Standard and Poor’s 500 (or S&P 500 for short). Compared to the Dow Jones, it contains the 500 largest U.S. companies and covers 11 different sectors (not just industrial companies).
Indices are also not just for stocks. You can even find them for other types of assets like bonds, precious metals, real estate, etc.
How Do Index Funds Work?
Quite simply, the goal of the index fund is to do one thing: Mirror the index that it follows. In the case of the S&P 500, when you buy an index fund for this index, you’re literally buying a fund that contains shares from all 500 of the companies in that index.
By comparison to other mutual funds or even ETFs, that might not seem so special. Lots of funds contain hundreds or even thousands of different shares. However, there’s a big difference.
Think about if you were going to try to build your own fund. You’d have to research which companies to invest in and constantly monitor them to ensure your fund was performing as best as it could. However, there would naturally be times you get it wrong and the fund loses money.
This happens more often than you’d think … even with professional fund managers!
Despite it being their full-time job to investigate the best opportunities and analyze data, many still pick a handful of companies that end up being losers and dragging down the average return of the whole fund.
By comparison, an index fund avoids all of that by simply buying only the companies that are part of that index – simple as that. There’s no complex strategy or analysis to be performed. The brokerage can more or less automate the fund to track the necessary stocks and make adjustments accordingly.
The result is that the index fund almost always beats the actively managed fund over the long haul. As someone who’s been investing for over 20 years, I can tell you that this is something I’ve witnessed over and over again.
You might get a few good years with an actively managed fund. But in the end, the index fund always seems to prevail.
What's the History Behind Index Funds?
The way I first learned about index funds was by reading a book called “The Little Book of Common-Sense Investing” by Jack Bogle. Bogle was the founder of the investment giant Vanguard, and perhaps one of the most prominent figures in the rise of index fund popularity.
In this book, Bogle made the argument that 80 percent of fund managers failed to beat their respective market index. He proposed that the average investor was simply better off capturing the average return of the market rather than attempting to beat it.
The reason why index funds always seemed to come out ahead was simple: Cost. An index fund tracking the S&P 500 returned an average of 12.3 percent from 1980 to 2005. A competing mutual fund only returned about 10 percent. The difference is that the typical mutual fund had higher expenses which ate up the profits.
Although he didn’t invent the concept of index funds, Bogle was the first to offer one when he formed Vanguard back in 1974.
Named the “First Index Investment Trust”, critics mocked the idea and dubbed it “Bogle’s Folly”. However, the investors continued to invest with Vanguard, and it wasn’t long before his index fund surpassed other well-known active funds.
More recently in 2007, legendary investor Warren Buffet made a friendly $1 million bet for charity against hedge fund Protégé Partners that they couldn’t beat the Vanguard 500 Index Fund.
Ten years later, he was right! The hedge fund made an average annual return of 2.2 percent while the index fund made a 7.1 average annual return.
What are the Pros to Index Funds?
There are many reasons why financial experts recommend that we should invest in index funds. Here’s how they can help you:
Capturing Market Performance
Like we already mentioned, the appeal of an index fund is that you can easily capture exactly what the market is doing. And to most people’s surprise, that’s a lot better than what the average mutual fund will yield.
This is particularly exciting when you look at long-term average returns. In the case of the S&P 500 index, the average annual return over 15 years is currently 10.76 percent.
But what’s even more interesting is that the low to high range is 4.24 to 18.93 percent. That means anyone who invested in this type of index fund for more than 15 years didn’t lose any money on average.
Low or No Cost
Another part of the appeal to index funds is that they are naturally incredibly cheap. Since the fund just copies the composition of the market index, there’s no need for a high-paid team of financial professionals to strategize and pick out the companies they want to invest in.
For instance, one of the index funds I use is the Vanguard 500 Index Fund (VFIAX). This fund carries a whopping 0.04 percent expense ratio, which works out to $4 for every $10,000 that I have invested. That’s cheap!
As ETFs grew in popularity, they also adopted this low-cost approach to investing. Since many of them invest in index funds, their expense ratios are significantly lower and more competitive than most mutual funds (which is part of their appeal).
It’s been exciting to watch how this has forced the big-time brokerages to adjust their game. For instance, Fidelity now offers a line of “ZERO” funds where you can invest in index funds with a zero-expense ratio and zero minimum opening deposit. It doesn’t get any lower than $0!
Investing in the Top Performers
The struggle you, me, or any investor would have if we were to buy stocks is to know which companies are going to be the winners and make the most gains. Even full-time fund managers whose job it is to pick these companies often get it wrong.
That’s one of the beauties of an index fund. It’s basically a curated list of the “winners”. You don’t have to do any research or apply any analysis because you already know that these are the top companies.
Like target-date funds or other mutual funds and ETFs, index funds are a healthy way to invest in hundreds of companies all at once. If you tried to buy stocks from all of those companies yourself, you’d pay an enormous amount of fees in the process.
Again, particularly with index funds, you’re not only diversified but your risk is spread out across the largest companies. Those companies didn’t get there by luck, so you know you’re working with solid investment choices.
When I think about all the time I’ve wasted over the years researching different stocks, reading up on the companies, and trying to compare analytics as if I work on Wall Street, it’s laughable.
For a while, I thought I could be “that guy” who beats the market if I put in the work to really investigate the right stocks to buy. But after a few years, my picks did barely as good as an index fund.
In hindsight, I would have come out ahead and saved myself all the trouble of trying to be the next Warren Buffet and just gone with an index fund.
What are the Cons to Index Funds?
Even though index funds have lots of financial experts rallying for them, there are some potential drawbacks. Here are the drawbacks from critics:
Average Market Performance
The problem with getting average returns is that they are “average” …
While it's awesome that someone with no investing experience can buy an index fund and capture the performance of the market, lots of stock enthusiasts reject this approach. Their argument is that by settling for average returns that you’ll miss out on opportunities to capitalize on companies with strong growth potential.
I’ve personally experienced this myself. A long time ago when the iPhone was relatively new, I bought a handful of shares of Apple stock. A year later, those stocks doubled in value!
Though that was probably just a lucky pick, lots of other people have earned extraordinary amounts of gains investing in young companies that eventually became well-known household names: Amazon, Google, Tesla, Netflix, Facebook, etc.
Yes, those companies were a risk. But as history has shown, the rewards were also quite handsome. A $10,000 investment in Amazon back at its IPO in 1997 would be worth more than $12 million today!
A Potential Bubble?
Unfortunately, anytime something becomes too popular, the laws of supply and demand will cause its price to become inflated causing a potential economic bubble. And that’s exactly what some critics of index fund investing fear may be happening.
Here’s the logic: When you invest in an index fund such as the S&P 500, you’re pouring money into these top 500 companies. The fund buys more shares of these stocks, the companies do better, and so their prices go up.
Now take this to the extreme. If everyone blindly buys index funds, then these companies will continue to artificially go up in price; perhaps beyond their fundamentals.
At some point, these prices could get so high that other company stocks or funds would look more appealing to investors. And once that happens, there would be a shift in where investor money goes.
When that happens, the bubble would burst and companies inside the index fund would drop in price. That could result in index fund investors taking huge losses.
In my lifetime, I’ve seen economic bubbles happen twice already. The first time was during the 2000s when people were investing in dot-com companies with no real rationale. Eventually, when these companies failed to turn a profit, their stocks came crashing down and took the country into a recession.
The second time was with housing. Throughout the 2000s, mortgage companies were approving people for loans that they had no way of affording.
This drove the price of houses up to record highs until around 2009 when it was revealed that these mortgage-backed securities were essentially worthless. Again, the country went into another recession.
Whenever someone warns about a potential bubble, we have to be aware of the facts and consider the possibilities. There’s always a very real chance that they might be right.
How Do You Invest in an Index Fund?
Index funds are some of the easiest funds to invest in. You can buy them as mutual funds or ETFs from virtually any major brokerage or discount broker available. Even robo-advisors (apps that pick your funds for you) will often choose index funds for their users.
Again, the smart way to buy them is through your IRA. That way you can avoid having to pay taxes on the capital gains or dividends as the funds increase in value.
These days, most workplace retirement plans will also have index funds available as an option. However, this will again be dependent on the plan administrator and what investment choices they have approved.
Which Type of Fund is Better for Your Retirement Plan?
So now the big question? Which one is the better investment for your retirement nest egg: The target-date fund or the index fund?
Like all investment decisions, it will all come down to a few basic points to consider:
- Performance – Which one gives better returns and is more sustainable? We already know that if we’re talking about a stock market index fund, then it's naturally going to produce a target-date fund because of the higher allocation to stocks. But if sustainability is your goal, then the target-date fund will become less risky as you get closer to your retirement date.
- Fees – Which one costs less? Hands-down, the index fund will be the cheapest option. With brokers like Fidelity offering funds with a zero percent expense ratio, there’s no competition. And don’t forget: The lower the fees, the more money that ultimately ends up in your pocket.
- Convenience – Which one suits your investment style? Let’s be honest: Are you going to take the time to rebalance your asset allocation every couple of years and make sure you’re becoming more secure by the time you retire? If the answer is even remotely “no”, then you should consider hitting the easy button and going with the target-date fund.
Personally, as someone who is more hands-on with their investments, my preference is to go with index funds. Since I like to invest aggressively and include diversification from other asset groups like mid or small-cap stocks and corporate bonds, I find that index funds make it easy for me to worry less about the performance of the fund and focus more on the composition of my asset allocation.
Since I’m already in the habit of logging into my accounts a few times per year, I don’t need a target-date fund to change my asset ratios for me. For me, this is really not that much extra work to manage this activity on my own.
Even if there was a target-date fund that aligned with my investment preferences, I probably would still not use it because of the higher fees.
When you’ve got the chance to invest in funds that charge barely anything or even no fees at all, that just means more money back in your pocket, so it's an easy choice. But again, that’s just my preference.
The Bottom Line
Target-date funds and index funds are two of the most commonly found types offered in nearly every retirement portfolio. They're both great options, but they have their individual pros and cons.
Target-date funds will automatically transition from risky high return investments to more stable investments as you get closer to your intended retirement date.
Since their introduction in the 1990s, they've been a great default investment for 401k plans and hands-off investors who don't want to bother with adjusting their asset allocation.
Target-date funds are a smart way to diversify your portfolio. Thanks to their simplicity, they truly are an option for those who wish to “set it and forget it”.
However, higher expenses and sometimes lackluster performance might cause a drag on your long-term gains. Though it might seem like we're talking about a few fractions of a percentage, that could translate into hundreds of thousands of dollars lost over time.
Index funds track broad market indices used by the investment industry to gauge how the market is behaving. Indices have been used since the 1800s, and it was in the 1970s that they became viewed as a potential investment opportunity.
The amazing thing about index funds is that they're a simple and incredibly cheap way to capture the return of the market. You don't have to bother with any research or analysis to know that you're getting an average return.
However, critics who don't want to settle for average will encourage investors to look for other investment opportunities. Furthermore, they warn that too much money going into index funds could even lead to inflated prices and create a potential economic bubble.
If you're trying to decide which is better for your retirement nest egg, the answer is to go with your gut. Know which type of investor you are and how the benefits of each type of fund might compliment your style. In the end, it’s all a matter of individual preference.