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'Target' Mutual Funds Prove Their Worth

NEW YORK (TheStreet) -- When target-date mutual funds recorded big losses last year, shareholders complained bitterly and legislators called for increased regulation. Some financial advisers argued that target-date funds had failed altogether.

But lately the funds have stormed back. Many have demonstrated they can perform their mission, providing sound investments for retirement savers.

Each target-date fund is designed to serve people who will be retiring near a certain date, such as 2020 or 2030. The funds include diversified portfolios of stocks and bonds. As the retirement date approaches, the portfolios automatically become more conservative, shifting away from stocks and into bonds. The aim is to protect retirees from suffering sizable losses.

The broad diversification should help to stabilize the funds. But as the markets tanked in 2008, many funds lagged behind the S&P 500 Index. Critics contended that target-date portfolios suffered large losses because they were poorly designed.

In fact, much of the underperformance can be attributed to big stakes in foreign stocks. Target 2040 portfolios currently have 27% of assets in overseas stocks, and 2010 funds have 13% abroad, according to Morningstar. In 2008, foreign stocks trailed the U.S. While the S&P 500 lost 37% of its value for the year, European funds dropped 49%, and diversified emerging market funds declined 54%, according to Morningstar.

Is it a mistake for target funds to hold foreign stocks? Hardly. Foreign stocks have soared lately, outpacing the S&P 500. That explains why target 2040 funds have returned 30% this year, outdoing the S&P 500 by 5 percentage points. As recent results have demonstrated, investors should hold foreign stocks because they sometimes outperform Wall Street and provide diversification.

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