While most funds have suffered lately, the downturn has been particularly excruciating for investors in target-date funds.During the third quarter, the average target fund lost 10%, compared with a loss of 8.4% for the S&P 500, according Ibbotson Associates, a Chicago research firm. "Many investors were shocked by the unexpected losses in target funds," says Tom Idzorek, Ibbotson's chief investment officer. Designed for retirement savers, the target-date funds hold broad portfolios of stocks and bonds. Because the big bond holdings should cushion results, investors expect the target-date funds to be relatively stable in downturns. But in their efforts to diversify, many target funds hold positions in foreign stocks and commodities. During the third quarter, emerging market stocks fell 26.9%, while commodities dropped 27.7%, according to Ibbotson. That dragged down average fund returns. The decline in target-date funds is significant because they have become enormously popular. Participants in 401(k) plans are currently putting half their new contributions into target funds, which have $277 billion in assets. Cerulli Associates, a financial consultant in Boston, estimates that the target funds will have $1.1 trillion in assets by 2012. If the target-date funds fail to deliver decent returns, the success of the 401(k) program could be in doubt. The target funds are offered for a series of retirement dates, such as 2020 and 2025. A saver can pick a fund with a target date near his scheduled retirement. As the saver approaches retirement, the fund automatically increases its fixed-income allocation. That way the portfolio becomes more conservative and is less likely to suffer losses that a retiree could ill afford.
The funds aim to offer investors a simple solution, but shopping for the right choice is complicated. Some portfolios are much more aggressive than others. Conservative choices have big stakes in bonds and cash, while riskier portfolios invest heavily in foreign shares. The asset allocation plays a big role in determining returns. Cautious funds fared best in the recent downturns. At the mild end of the spectrum is American Century LIVESTRONG 2015 ( ARFAX), which outdid the S&P in the third quarter, losing 6.54%, according to Morningstar. American Century had 50.3% of assets in fixed income, 39.5% in U.S. stocks, and only 9.6% in foreign stocks. At the other end of the risk spectrum is AllianceBernstein 2015 ( LTEAX ), which lost 12.11% in the quarter. The relatively aggressive fund had 26.8% in fixed income, 45.3% in U.S. stocks and 27.3% in foreign stocks. Fund companies like to say that you can buy a target fund and forget about it. But shareholders need to keep an eye on their investments because the asset allocations can shift. When target funds began appearing early in this decade, many had heavy weightings in fixed income. Then stocks rallied in 2003 and delivered gains for five consecutive years. Target funds with bigger stock allocations began outdoing their more cautious peers. After falling in the standings, some funds increased their stock allocations. By 2007, the average target fund had 68% of assets in equities, compared with 55% in 2002. Fund companies had increased equity allocations just in time to be clobbered by the downturn of 2008.
Portfolio managers said they were increasing equity holdings to better serve shareholders, who would need big capital gains to support long retirements. But the shifts looked suspiciously like performance chasing -- buying hot assets -- a practice many fund companies claim to avoid. Are the target funds done experimenting with different asset allocations? Not a chance. Now that the equity-heavy funds have dropped in the performance standings, you can bet that some funds will be shifting to greater doses of fixed income. "Once the dust settles, people are going to look around, and the composition of some portfolios is going to change," says Jeff Tyler, portfolio manager of American Century LIVESTRONG. The weak showing of target funds is particularly distressing for investors who just started using the funds in the past year. Following the urging of financial advisers, many 401(k) participants switched from boring fixed-income choices to equity-heavy target funds. If you are one of the unlucky shareholders, should you abandon target funds altogether? Not yet. With their broad diversification, many target funds seem like sensible choices for the long term. But nervous investors should pick conservative funds that can survive whatever downturns the market delivers.