When it comes to investing for the long term, two options often steal the spotlight: target-date funds and index funds. Both have their virtues, but which one is right for you?
Target-date funds are designed to change their assets over time, adjusting to more conservative, less risky investments as retirement or another event approaches. These funds offer a diversified, hands-off approach to retirement investing, making them attractive for those who prefer a more "set it and forget it" approach. Meanwhile, index funds are passively managed mutual funds or exchange-traded funds (ETFs) that track a specific market index, such as the S&P 500. They give you broad exposure to the market and lower costs.
Both are very popular. Passive index funds now hold more assets in the U.S. than their actively managed peers. Target-date funds, for their part, are an often-chosen investment route, with a 2022 Investment Company Institute analysis reporting that the percentage of 401(k)s participants invested in target-date funds grew from about 25% in 2007 to almost 60% by the early 2020s.
In this article, we'll dive into the key differences between the two, exploring the pros and cons of each, and review which factors to consider when choosing the path that best aligns with your goals and risk tolerance.
Key Takeaways
- Target-date funds automatically adjust their assets over time, becoming more conservative as the target retirement date approaches, while index funds track a benchmark and its weighting over time.
- Index funds typically offer lower costs, broad market exposure, and simplicity, while target-date funds are a hands-off, all-in-one investment vehicle.
- Factors to consider when choosing between target-date and index funds include your investment goals, risk tolerance, and time horizon.
- Both are often the funds of choice, with passive index funds now leading their active peers in assets under management in the U.S., and almost 60% of 401(k) participants invested in target-date funds.
Index vs. Target-Date Funds
Index Fund
Aims to match the performance of a specific stock index.
Usually passively-managed.
Typically owns stocks or bonds.
Investors can build a portfolio using several index funds based on their risk tolerance and goals.
Target-Date Fund
Aims to build and rebalance a portfolio based on the investor's estimated retirement date.
Are automatic like passive funds, but are actively managed to ensure their glide path is smoothed out.
May own stocks, bonds, other securities, or even be composed of other mutual funds.
The asset allocation is set by the fund manager.
Index Funds
Index funds are designed to track the performance of a specific market index, such as the S&P 500 or the Nasdaq Composite index. These funds aim to replicate the returns of the underlying index by holding a basket of securities that closely match the composition and weighting of the index.
For example, an S&P 500 index fund would invest in the stocks that make up the S&P 500 index, with each stock weighted according to its market capitalization. By doing so, the fund tracks the performance of the stocks in the index.
Index funds follow a passive investment strategy, meaning that fund managers do not actively select individual securities or time trades in the market. Instead, they focus on maintaining a portfolio that closely tracks the target index. The upshot is that the less management, the less fees you generally pay.
While index funds aim to track their target indexes closely, there may be slight deviations in performance because of fund expenses, tracking errors, and the timing of cash flows. However, these differences are generally minimal, and index funds provide returns quite close to their underlying indexes. You can also choose funds that mirrorvariousf index funds depending on the assets, trends, themes, sectors, and so on that you wish to put your money in.
Advantages of Index Funds
Broad market exposure: Index funds provide you with exposure to a wide range of securities within a single investment vehicle.
Low Cost: Index funds typically have lower expense ratios than actively managed funds, as they have lower turnover and fewer operational costs. The average passively managed index fund in 2022 had an expense fee of 0.05 compared with 0.44 for actively managed mutual funds.
Simplicity: Index funds are a straightforward, passive approach to investing, eliminating the need to select individual securities.
Drawbacks of Index Funds
Lack of flexibility: Index funds are designed to track a specific index and do not have the flexibility to adapt to changing market conditions in a downturn. When this happens, index funds will decline in value along with their target indexes.
Limited potential of outperformance: Since index funds track the performance of their target index, they often don't beat the market, not least since the most popular indexes largely represent that market.
How to Invest in Index Funds
Index funds are available as both mutual funds and ETFs, providing investors with flexibility in how they invest. Mutual fund index funds can be purchased directly from the fund company or through a brokerage account, while index ETFs can be bought and sold on stock exchanges throughout the trading day.
When selecting an index fund, consider the fund's target index, expense ratio, tracking error, and performance history. It's also important to assess how the index fund fits within your overall investment strategy and risk tolerance.
Target-Date Funds
Target-date funds are designed to simplify retirement investing. These funds automatically adjust their asset allocation over time, becoming more conservative as the target retirement date approaches. They are also guided toward a specific retirement year, such as 2030, 2040, or 2050.
When you invest in a target-date fund, you choose the fund with the target date closest to your expected retirement year. The fund manager then constructs a diversified portfolio of stocks, bonds, and other assets, with the allocation based on the time until the target date.
As that date approaches, the fund typically reduces its exposure to stocks and increases its holdings in bonds and other low-risk assets. This gradual shift, known as the fund's glide path, helps to ensure your risk matches your changing needs as you near retirement.
Advantages of Target-Date Funds
Diversification: Target-date funds typically invest in a mix of asset classes, providing broad diversification within a single investment vehicle.
Professional management: Fund managers handle allocating and rebalancing the mix of assets in the portfolio, guided by the fund's target date and risk profile.
Simplicity: Target-date funds eliminate the need for you to manually adjust your asset allocation over time.
Drawbacks of Target-Date Funds
Higher fees: Target-date funds often have higher expense ratios than index funds because of the active management involved in adjusting the asset allocation.
Lack of customization: You'll have limited control over the specific holdings and asset allocation of target-date funds, which may not align perfectly with their personal investment preferences.
One-size-fits-all approach: Target-date funds follow a preset glide path based on the target retirement date, which may not suit every investor's individual risk tolerance and investment goals.
How to Invest in Target-Date Funds
Target-date funds are available through most employer-sponsored retirement plans, such as 401(k). They might come with matching funds from your employer. Target-date funds can also be purchased directly from mutual fund companies or through brokerage accounts that offer mutual funds.
In recent years, a handful of asset managers like iShares have introduced target-date ETFs. These funds combine the automated asset allocation of target-date funds with ETFs' low fees and the ability to trade like shares. However, target-date ETFs are still relatively new. They might have low assets under management and trading volume, impacting their liquidity (your ability to trade them quickly).
Most target-date funds are still structured as mutual funds, particularly those offered through employer-sponsored retirement plans.
When selecting a target-date fund, consider the fund's glide path, underlying holdings, the fund manager's performance history, and fees. Of course, ensuring that the target date aligns with your expected retirement timeline and risk tolerance is essential.
Factors to consider when choosing between target-date and index funds
Here are the preferences and scenarios that would tend to support choosing a target-date fund:
- You like simplicity: If you prefer a hands-off approach to investing and want a simple, all-in-one solution for retirement planning, target-date funds may be worthwhile.
- You don't want to adjust this part of your portfolio over time: If you want your portfolio to automatically adapt its asset allocation over time without manually rebalancing, target-date funds can provide this convenience.
- You're nearing retirement: If retirement is approaching (e.g., within 10 to 15 years), target-date funds can reduce your portfolio's risk exposure by gradually shifting toward more conservative assets as your retirement gets closer.
- You have an employer-sponsored retirement plan: If your employer-sponsored retirement plan, such as a 401(k), offers target-date funds, it can be a convenient and accessible option for retirement investing.
Here are the preferences and scenarios that could mean an index fund is a better fit:
- You're cost-conscious about fees: If you prefer low-cost investments and want to minimize expenses, index funds typically have lower expense ratios than actively managed funds, including most target-date funds, though fees for these funds have been dropping over time, too.
- You have a longer time horizon: If you have 20 or more years until retirement, index funds can offer broad market exposure and the potential for long-term growth, as you have more time to ride out short-term market fluctuations. That said, target-date funds will have higher-growth assets in the earlier part of your time horizon if you are invested in them longer.
- You want to customize your portfolio: If you're going to change up your asset allocation to create a portfolio mix that includes index funds and best fits your risk tolerance and investment goals, then these funds might work better for you.
- You value transparency: If you value knowing precisely what you're invested in, index funds will match the market index you've chosen to put money into.
- You're investing through a taxable account: If you are investing in a taxable account (i.e., not a tax-advantaged retirement account), index funds can be more tax-efficient than actively managed funds because of their lower turnover and reduced capital gains distributions.
These are general guidelines, and the best choice for you will depend on your financial situation, risk tolerance, and investment objectives. Consulting with a financial advisor can help you determine your best investment strategy.
What is a Fund of Funds?
Many target-date funds are called funds of funds. That means they invest their money in other mutual funds rather than buying individual stocks or bonds. Many funds of funds invest in index funds, building a diversified portfolio and keeping fees relatively low.
How Do the Tax Implications for Index and Target-Date Funds Compare?
Index funds, particularly those that track broad market indexes like the S&P 500, tend to have lower turnover than target-date funds. This means fewer transactions within the fund, which can result in fewer capital gains distributions. Thus, index funds are generally more tax-efficient, especially in taxable accounts. Target-date funds, meanwhile, may have more turnover because of their regular rebalancing and adjustments over time. This can lead to more capital gains distributions. However, if you hold your target-date fund or index fund within a tax-advantaged retirement account, such as a 401(k) or individual retirement account, you typically won't owe taxes on investment gains until you withdraw money from the account.
Can I Invest in Both Target-Date and Index Funds?
Yes, you can combine target-date and index funds to balance simplicity and customization.For example, you might invest a part of your retirement savings in a target-date fund to ensure your asset allocation remains age-appropriate while using index funds to build a more personalized portfolio that complements your target-date fund holdings. There are other options, too, like investing in target-date funds that hold index funds. When combining target-date funds and index funds, be mindful of the holdings of your overall portfolio to avoid accidentally doubling up on stocks, assets, or sectors that are held in both.
The Bottom Line
The choice between index and target-date funds depends on your investment goals, risk tolerance, and the level of engagement you want with your portfolio. Index funds are straightforward for broad market exposure, while target-date funds provide a more hands-off approach, automatically adjusting the asset allocation as the years go by. Both options have their merits, and the decision ultimately comes down to what aligns best with your financial objectives and investment style.
