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.
Helped by their foreign holdings, most target funds now have decent long-term records. During the past five years, target 2010 funds have returned 2.2% annually, compared with 0.4% for the S&P 500. Many financial advisers remain unimpressed, arguing that investors should build customized portfolios and not rely on off-the-rack target funds. So far, plenty of investors have been ignoring the critics. While most kinds of stock funds suffered withdrawals in 2008, target funds had inflows of $57 billion for the year. This year, the funds are on pace to receive investments of $60 billion, Morningstar says. Make no mistake, shopping for a target fund can be difficult. Besides comparing fees and track records, investors must pay special attention to asset allocations. Funds with long time horizons tend to have big equity allocations. The average 2040 fund has 90% of assets in equity. But funds have different strategies for increasing bond allocations as the retirement date approaches. Some companies take conservative paths, shifting to big bond allocations. Other portfolios have hefty stock holdings at retirement. The range of allocations is particularly wide for 2010 funds. Equity allocations range from 25% to 72%. Funds with sizable stock holdings suffered heavy losses in 2008, shocking some shareholders who thought their nest eggs were safe. Among the worst losers was Oppenheimer Transition 2010 ( OTTAX), which had 70% of assets in stocks and lost 41% for the year. Seeing that disappointing record, some investors may prefer avoiding target funds. But whether you like target funds or not, you could wind up using one some day. Most 401(k) plans offer savers only a limited number of options. And these days, more plans are including a target-date fund on the menu. In a typical plan, investors can choose a target fund or a handful of other options including a money market, a cautious bond fund and a stock fund. In many cases, the target fund may be the best choice, providing immediate diversification.
Most investors who shop for a target fund should stick with cautious choices. A solid performer for investors who can stand moderate risks is Fidelity Freedom 2010 ( FFFCX), which has 52% of assets in equities. The fund has returned 3% annually during the past five years. Conservative investors may prefer MFS Lifetime Income 2010 ( MFSAX), which has only 30% of assets in stocks. The fund has returned 4.1% annually during the past three years, outdoing the S&P 500 by more than 9 percentage points.