Target-Date vs. Index Funds: Is One Better?

In the world of mutual funds, there are two main categories: actively managed funds and passively managed (index) funds. (For more, see: Passive vs. Active Management.)

Actively managed funds are run by portfolio managers who buy and sell securities within the fund in an effort to achieve the fund’s investment objective. Target-date funds are a variety of actively managed fund that are designed to “mature” at a specific time. 

Passively managed index funds simply buy and hold a basket of securities that also fit the fund’s objective without any portfolio turnover.

Both target-date and index funds are designed to run on automatic pilot, but the question of which is better requires the examination of several variables. (For more, see: Active Management: Is it Working for You?)

Index funds are probably the simplest type of mutual fund available today. These funds simply purchase all of the securities that are listed in a given stock or bond index. For example, an S&P 500 Index fund owns each of the 500 stocks that are included in that index, and each share of the fund represents an undivided interest in each of those 500 companies. There are index funds available for virtually every financial index in existence, both foreign and domestic. (For more, see: The Lowdown on Index Funds.)

Target-date funds are managed so that the securities in the fund are allocated in an increasingly conservative allocation as the target date approaches. For example, a thrift savings plan — the retirement plan provided by the federal government to employees — offers five core funds that range from conservative to aggressive and also several life cycle funds that mature in 10-year intervals, with the next one maturing in 2020. The life cycle funds are funds of funds that maintain allocations of the five core funds. When they are first issued, 24% of assets are held in the two bond funds with the rest allocated among the three stock funds from the five core funds. Then the funds are slowly reallocated every 90 days until the target date is reached. At this point, the initial allocation is reversed, where 24% of the funds are then allocated among the three stock funds and the remaining 76% between the two bond funds. (For more, see: Life Cycle Funds: Can it Get any Simpler?)

Most other target-date funds work in a similar manner, where the initial asset allocation is usually geared toward growth and is gradually reallocated to a stable or income-producing portfolio. These funds now boast total assets in excess of $500 billion and have become increasingly popular in 401(k) and other employer-sponsored retirement plans. (For more, see: Target Date Funds: More Popular, Cheaper Than Ever.)

As broad fund categories, target-date and index funds are difficult to compare in many respects because they differ in both structure and objective. Target-date funds are usually rather complex instruments, internally speaking, while index funds are totally transparent and static by nature. Target-date funds come with a complete range of fee structures, while index funds typically charge little or nothing due to their passive management. Target date funds also may invest in several different types of securities, including common and preferred stocks, corporate and Treasury securities, and other mutual funds in some cases. And because the latter type of fund usually is designed to provide increasingly conservative returns over time, any comparison to an index fund is fundamentally skewed. (For more, see: Who Actually Benefits from Target Date Funds?)

Investors who wish to compare these two types of funds will probably need to pick two specific funds and compare their performance over a few separate but identical time frames. But investors need to keep their objectives in mind when they view this data because those who will need to access their money at a certain time — such as when the target date in question arrives — may not be good candidates for an index fund because of the chance that that index could drop substantially just prior to when the money is needed. Those who will need to liquidate their funds within a few years will probably be better off in a target-date fund because the odds of sustaining a large loss will diminish with time as the target portfolio becomes more conservatively allocated. (For more, see: 5 Reasons to Avoid Index Funds.)

Those who will not need to make a withdrawal for at least 15 or 20 years may come out ahead in an index fund; for example, a retirement saver in her 40s might be wise to buy an index fund and stay in it until she hits 65 or 70 because the index has posted average returns of 8% to 10% a year during that time span. Even if the market corrects just prior to retirement, she may still come out ahead of a target-date fund because she participated in more of the growth during the rest of the time period. (For more, see: Can Enhanced Index Funds Deliver Low-Risk Returns?)

Comparing target-date funds to index funds is like comparing apples to oranges. Each type of fund is designed for a somewhat different purpose, although both types of funds allow investors to grow their money on automatic pilot in a sense. For more information on index and target date funds, visit Morningstar Inc.’s (MORN) website or consult your financial advisor. (For related reading, see: Few Target-Date Managers Invest in Their Own Funds.)