Target-date funds don't always hit the bull's-eye for their investors. Some of these retirement vehicles charge high, performance-sapping fees. Others have a misguided asset strategy.
Taken together, that's a problem, because these funds are increasingly popular, with retirement-minded investors depending on them to deliver a comfortable nest egg. The funds' assets hit $880 billion in 2016, up 15.3% from 2015, according to investment research firm Morningstar. Many people are signed-up for one in their 401(k) plan. But if their employer chose a blah fund provider, employees are in a jam.
Certainly, the target-date concept is a good idea, and many of these funds churn out decent returns. Each of these funds has a date attached, when their investors intend to retire. A 30-year-old today, for instance, might enroll in a 2055-dated fund, intending to collect then.
Starting out when its investors are young, a typical fund is heavily weighted toward equities. But over time, the allocation grows more conservative, meaning it tilts to favor bonds. The beauty of this is that the change, called the glide path, happens automatically: investors don't have to do nothing.
Target-date funds, created in the 1990s, really took off after Congress passed a law in 2006 encouraging employers to enroll workers in retirement plans and allowed target-dates as a default position. Before, employees had to opt in to a retirement plan; now they have to opt out. Thanks to the power of inertia, target-date funds have grown mightily since.
Another factor in their rise is that investors regard them as secure. A 2012 survey by the Securities and Exchange Commission found the top reason people chose a target-date fund was "it seems like a safe investment for retirement."
Here's the rub: just because they may have a lot of bonds, doesn't make them safe. Look at Oppenheimer Transition 2010, which lost a stunning 41% in 2008, a mere two years before its investors were to retire. The Oppenheimer fund's loss, the worst fund decline that housing crisis year, stemmed largely from the its large dollop of mortgage-backed bonds.
Target-date funds are funds of funds - that is, collections of other mutual funds. Even the best target-date providers favor their own funds. That's fine if the target-date sponsor is a low-fee, nicely performing house like Vanguard -- not so great if it's a doggy fund firm.
So what should you be aware of in particular?
First the good news. On average, fees for target-date funds have come down over time, by Morningstar's reckoning - now averaging 0.71% of assets yearly, versus 0.99% five years before. The reason is that more and more of them use index funds, which are cheaper, because they don't need to pay armies of managers and analysts.
But not every target-date sponsor has gotten cheap. Lofty fees tend to eat into performance. Consider State Farm LifePath 2020 (SAWIX) . Depending on the share class, its expenses can range as high as 1.49%, Morningstar data show. As Morningstar analyst Jeff Holt writes, the "funds generally remain expensive compared with peers, particularly given that their underlying investments are passively managed," meaning index funds.
State Farm regularly is at the back in peer performance rankings of the Morningstar moderate target-date category. Over ten years, the company's 2020 fund has lagged behind the category average by 1.6 percentage points. State Farm disputes Morningstar's methodology, saying its funds are cheaper than the research outfit believes.
That's not to say, however, that higher costs always mean substandard returns. T. Rowe Price Retirement 2020 (TRRBX) , for example, charges 0.66% and has one of the best performances in its Morningstar category, usually ranking at or near the top.
Bad asset mix
Another red flag to look out for: gimmicks meant to generate superior performance sometimes lead to big slip-ups. For instance, Manning & Napier Target 2020 (MTNIX) avoided the common practice of holding more than 20 funds representing different asset classes, in favor of using just two diversified funds.
That approach, Morningstar's Holt contends, results in swift performance swings. Its small exposure to financial stocks helped it for 2016's first three quarters, when they weren't doing well, but a turnaround for financials in the year's final period torpedoed everything. In a year when the S&P 500 jumped 11.9%, the Manning & Napier fund only managed a 3.5% gain. Over the years, it has generally trailed its peers.
Another strategic misfire was Wells Fargo's (WFC) preference for equal-weighted funds, which avoided the traditional market value method. Equal weighting ends up giving greater prominence to smaller stocks -- and when those aren't in vogue, look out. This year, the Russell 2000, which tracks small-caps, has advanced only half as high as the large-cap-focused S&P 500. For every period over the past ten years, the Wells Fargo Target 2020 (STTRX) has not kept up with peers. Over the last decade, it is behind 2.1% annually.
So Wells is scrapping equal weighting and shifting to a factor-based technique, which presumably will assess stocks by such measures as low volatility. Holt cautions that the effectiveness of "these untested strategies remains unknown." Neither Manning & Napier nor Wells would comment.
How do you know if your target-date fund is a loser? Examine fees and past performance along with how a fund fits your investment needs. A good place to check out your 401(k) is research site BrightScope, which lets you compare your retirement plan's fees and choices to others. If your target-date fund falls short, try to talk your employer into getting a better one.
More of What's Trending on TheStreet: