Target date funds (TDFs) utilise some of the core principles of successful long-term investing. Find out what they are, why glide path investing could suit you, and how to invest with a TDF.
In the world of investing, there’s a growing interest in strategies that align with specific financial goals and timelines. Target Date Funds (TDFs) are one such strategy, designed to simplify the investment process by automatically adjusting the asset mix as the target date approaches.
This article will delve into what TDFs are, how they operate, and the advantages and disadvantages they offer. We’ll also explore the concept of glide path strategies and how they relate to TDFs, providing a comprehensive understanding for those considering this investment approach.
What is a target date fund (TDF)?
A Target Date Fund (TDF) is an investment fund structured to potentially grow assets for a specified time frame. The decision regarding which instruments are included in a TDF is heavily influenced by the fact that there is a deadline by which the scheme is expected to mature.
TDFs can be used to save for retirement, or short-term and medium-term goals such as buying a house or taking a career break.
Whatever the timeline, TDFs will typically adjust their asset allocation to be more conservative as the target date nears. This rebalancing allows for growth to be prioritised in the early stages of the scheme, and for any potential gains to be better protected as the TDF nears maturity.
TDFs are popular among investors seeking a hands-off approach, as they provide a diversified investment strategy that evolves over time without the need for active management by the investor.
The primary appeal of TDFs lies in their structured investment approach and automatic rebalancing. Investors select a fund with a date that aligns with their financial goals, and the fund managers then oversee the ongoing portfolio adjustments. This makes TDFs an attractive option for those who prefer a set-and-forget investment strategy.
How do target date funds (TDFs) work?
Target Date Funds operate by adjusting their asset allocation over time, shifting from a growth-oriented mix to a more conservative one as the target date approaches. This process is known as the fund’s glide path.
Take for example, a TDF with a target date of 2040. It might start with a high allocation in growth stocks. Any short- and medium-term price volatility in the stock market could be expected to be ridden out by the time the plan matures. As 2040 approaches, the fund gradually shifts towards bonds and other fixed-income securities to preserve capital and reduce risk.
This automatic adjustment can be convenient for individuals who may not have the time to manage their investments actively. The glide path ensures that the fund’s risk level is aligned with the investor’s time horizon, aligning with the principle of taking the right risks at the right time.
Tip: Different style glide paths appeal to different investors. Consider your investment goals and choose the right path for you.
Using a glide path investment strategy
The glide path is a crucial component of Target Date Funds, dictating how the fund’s asset allocation changes over time. When the time to reach the goal is long, the focus is on growth, with a higher allocation to equities. As the target date nears, the focus shifts to preservation, increasing the allocation to bonds and other low-risk investments.
This strategy allows investors to benefit from the potential higher returns of equities during the early years while gradually reducing risk as the target date approaches. For instance, a young investor with a retirement date several decades away might start with a TDF heavily weighted in stocks.Over time, the fund will automatically shift towards bonds, aiming to reduce exposure to more volatile assets.
Tip: Review the fund’s fees before investing. High fees can erode investment returns in the long run.
Types of glide paths
Glide paths can vary significantly between different Target Date Funds, influencing how the fund’s asset allocation changes over time. Understanding these variations can help investors to choose a TDF that aligns with their risk tolerance and investment goals.
Declining glide path
The most common type, a declining glide path, begins with a high allocation to equities and gradually shifts towards lower-risk bonds as the target date approaches. This strategy aims to maximise growth potential in the early years while preserving capital closer to the target date, focusing on early high-risk exposure.
Rising glide path
A rising glide path starts with a conservative asset allocation and becomes more aggressive over time. This approach is less common and is not designed to achieve a specific goal on a specific target date. It might appeal to investors who are initially less comfortable with high risk. Once they are more confident, and have a better understanding of the glide path technique, they may wish to change to a declining glide path.
Time is your friend; impulse is your enemy. Take a long-term perspective.
John C. Bogle
What are the advantages and disadvantages of TDFs?
Target Date Funds offer several advantages, but they also come with potential drawbacks. Understanding the details can help investors to make better-informed decisions.
- Straightforward: TDFs provide a straightforward investment solution, automatically adjusting the asset mix over time.
- Diversification: These funds typically invest in a broad range of asset classes, reducing risk through diversification. To learn more about how diversification impacts risk management, check out this guide.
- Professional management: TDFs follow a professionally designed investment strategy that automatically adjusts the portfolio according to the fund’s glide path, saving investors time and effort.
- Tax-efficiency: TDFs may be eligible for saving and investment schemes which benefit from preferential tax treatment.
- Lack of customisation: TDFs follow a predetermined glide path, which may not align with every investor’s risk tolerance or financial goals.
- Potentially higher fees: The convenience of professional management can come with higher fees compared to managing investments independently.
- Market risk: Despite the gradual shift towards conservatism, TDFs are still subject to market fluctuations, which can impact potential returns and losses. Explore the essentials of market assessment through this investment guide.
- Lack of flexibility: TDFs rely on a specific strategy being chosen and followed – which may limit the ability to adapt to market events over time.
How to invest with a TDF
Investing in a Target Date Fund is relatively straightforward. Investors select a fund with a target date that aligns with their financial goals.
Target Date Funds are typically available through employer-sponsored retirement schemes or brokerage accounts. It’s important to review the fund’s glide path and fees to ensure that they match your investment objectives.
Tip: One of the major benefits of TDFs is the way they tap into the theme of recurring investing.
For more detailed information, consider exploring the Managed Target Goal Model Portfolios or resources from established financial firms such as Vanguard, Fidelity, or BlackRock. If interested in creating your own diversified portfolio, explore steps in how to build an investment portfolio.
Final thoughts
Target Date Funds are designed to follow a long-term investment path with automatic adjustments over time, which may appeal to investors looking for a hands-off approach and a structured way of pursuing their personal goals.
As might be expected of a product which focuses on long-term investing, TDFs aim to offer gradual potential capital growth rather than outperform the markets. The management fees associated with TDFs mean that their performance often lags behind that of benchmark indices, but that downside then needs to be balanced against the potential for including them in investment schemes which benefit from preferential tax treatment.
Learn more about investing in funds on the eToro Academy.
FAQs
- How long do bear markets last?
-
The average length of a bear market is 9–15 months. The definition of a bear market is a fall of 20% or more from a previous high and while they can be an uncomfortable experience for investors, those adopting a long-term strategy can find it easier to ride out the inevitable peaks and troughs of the markets. Rotating in to lower-volatility assets when your plan is nearing maturity can help you to meet your investment aims even if there is a short-term shock.
- What is the compounding effect?
-
Compounding is the “snowballing” effect which occurs when investors reinvest any interim income back into their portfolio. If a stock pays a dividend, or a bond pays a coupon, and you buy more stocks or bonds instead of drawing out the cash, the size of your income-generating asset pool increases. That results in the dividends and coupons in turn being greater, and so on.
- What is portfolio rebalancing?
-
Portfolio rebalancing involves buying and selling assets to ensure that your portfolio is constructed in a way which best suits your long-term objectives. If you want a portfolio split 50-50 between bonds and stocks, then the relative outperformance by stocks over a period of time might result in the value of your portfolio being weighted 60-40 in favour of stocks. Selling stocks and buying bonds would restore the 50-50 target allocation.
- What are the alternatives to TDFs?
-
The convenience, potential tax breaks, and time-line structuring of TDFs make them a popular choice among investors, but there are alternatives to consider, such as exchange-traded funds (ETFs).
These relatively low-cost instruments include tracker funds, which aim to replicate the performance of a particular sector or index, such as the S&P 500 or the bond market. If you were self-managing your portfolio along TDF principles, you might make cost savings, but would be responsible for adjusting the balance of the portfolio over time.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments.
This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Not all of the financial instruments and services referred to are offered by eToro and any references to past performance of a financial instrument, index, or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.