By Al Shams | Business Sense

Target date funds have emerged on the investment scene the past 10 years and hold hundreds of billions of dollars in investor assets. During 2014, more than $50 billion flowed into these entities. May 22 IssueMany readers may hold these securities and be unclear how they operate.

Target date mutual funds are open-end mutual funds that automatically reallocate an investor’s retirement funds based on his age or retirement date. The monies are typically allocated into stocks, bonds or cash. Like any market-based investment, these values will fluctuate, and returns are not guaranteed.

A young worker planning on a 2050 retirement would select a target date 2050 fund, while an older worker with a 2025 retirement would select a 2025 target date fund.

Because of the longer investment periods, the 2050 fund would be weighted toward stocks with a small percentage in bonds and cash. The 2025 fund would hold higher allocations of bonds and cash than the 2050 fund.

These allocations are based on the generalized analysis that long-term investments in stocks outperform bonds or cash. Work done by the independent research group Ibbotson supports this long-term analysis.

The key point supporting this allocation process is that historical data show that over very long periods, stocks outperform bonds, bonds outperform cash, and inflation outperforms cash.

The advantages of target date funds are that they are an automatic, hands-free, low-cost way to allocate capital and that, if followed strictly, they should reduce emotional reactions to the markets and the economy.

But I believe that the disadvantages far outweigh the perceived benefits. The biggest faults I see:

  • The allocation process is based on 30-to-60-year analysis of returns by various investment alternatives.
  • This process requires tremendous patience and discipline to stay with it even if it underperforms for many years.

In my 40-plus years in the investment market, patience is the one thing few investors have. If something doesn’t work for a few years, “sell it and let’s move on” is the cry. Many times, good operating progress for a company is not reflected in the share price in the short run.

Mike Tyson has a saying: “Everybody has a plan until they get punched in the face.”

The D-Day invasion of Normandy was carefully planned, but when the first shots were fired, those plans were obsolete. Very few things went as planned that day. Courage, innovation and flexibility saved the day.

This is a crucial point: Target date funds might work, but in my view they require tremendous discipline in the face of many years of possible underperformance. I believe that few could emotionally deal with that circumstance.

  • The investment world is dynamic; capital flows in and out of situations quickly. The target date approach is a fixed, static strategy in a highly dynamic world. No football team would run the same play time after time; the opponent would quickly adjust and destroy the team with the static approach.
  • The United States has its lowest interest rates in 80 years. Western Europe has its lowest rates in the last 400 years. Having lived through the late 1970s and early 1980s, when 30-year U.S. government bond rates topped 13 percent, I can’t see much opportunity today in long-term bonds.

I believe we are at the end of a 34-year bull market in bonds. If interest rates return to the levels of 15 years ago, bonds likely will incur big market value losses. Hence, you should seriously reconsider any significant allocation toward long-term bonds.

  • In classic investment analysis, investments should be selected on the basis of what offers the best current intrinsic value, not on some fixed formula.
  • An article in the April 13 issue of Investment News disclosed that of 57 target date funds analyzed by Morningstar, 32 managers of those funds did not have even $100 of their own money in the fund.
  • Target date funds do not incorporate insight, flexibility or creativity into the process. I believe these are crucial items to consider.

In my opinion, the disadvantages outweigh the perceived advantages.

Al Shams is a Sandy Springs resident, a former CPA and an investment professional with more than 35 years’ industry experience.