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Off Target: On the Underperformance of Target-Date Funds

Are you saving for retirement using a target-date fund or TDF? Might you consider an alternative that outperforms your TDF and costs less?

Target-date funds (TDFs) are popular vehicles that provide investors with an evolving asset allocation to meet their needs at some future date (e.g., retirement), according to David Brown, an assistant professor at University of Arizona and Shaun Davies, an assistant professor at the University of Colorado at Boulder

While TDFs provide investors with extensive diversification and active rebalancing, TDFs are also a type of fund-of-funds. As such, Brown and Davies wrote in their research paper, Off Target: On the Underperformance of Target-Date Funds, that investors pay multiple layers of fees as most TDFs charge fund-of-funds’ fees and also hold funds that collect additional fees. In fact, their analysis shows that TDF sponsors collectively charged nearly $2.5 billion in excess fees in 2017 alone.

In their paper, the authors show that TDFs are easy to emulate with a portfolio of cost-efficient exchange-traded funds (ETFs) and they coin these portfolios Replicating Funds (RFs). 

According to Brown and Davies, RFs substantially outperform TDFs, exhibit low tracking error, do not suffer from cash drag, and require infrequent rebalancing. Plus, the authors provide a normative rule-of-thumb for investors to construct their own RFs using low-cost ETFs.