Target date funds (TDFs) were first created in the 1990s and have proved to be hugely successful in the US, with more than $700bn (£457bn) invested in them at the end of 2014 according to research from Morningstar. We are now starting to see this trend take hold on this side of the Atlantic.
The target date
TDFs are diversified multi-asset funds where savers are required to decide only the amount they wish to invest and the “target date” when they expect to begin making withdrawals for a future goal.
The target date is the time at which the investor will expect to begin withdrawing their money. The unique characteristic of a TDF is that the fund manager adjusts the asset allocation depending on the closeness to the target date. The portfolio gradually reduces in risk over time as the investor changes from having a growth objective at the beginning towards a withdrawal objective at the target date. The growth objective requires a higher risk-return strategy – the withdrawal objective requires a lower risk-return strategy. TDFs gradually transition from one to the other on approach to the target date which is the ‘turning point’ between the two. This is a common sense investment approach but conveniently delivered within a single fund.
Risk, return and time
Deciphering how much risk/return potential to have in a portfolio is a key decision for any investment strategy. Cash is a safe asset in the short run but a risky asset in the long-term because of inflation. Bonds and equities have a higher return potential, but that comes with a higher level of short-term risk because of volatility. Over the long-term, their ability to beat inflation means they are an essential ingredient to an investment portfolio.
Traditionally, savers needed to choose a level of risk in a portfolio that is right for them, bearing in mind that what’s right for them will change over time. Sometimes this is done by working out an individual’s general attitude towards risk that considers how much risk feels “comfortable”. The reality is that few people like any risk at all, so attitude to risk is not necessarily aligned with the risk-return profile needed to achieve their investment goals.
TDFs take a different approach and consider risk profile as defined by time horizon. This is known as “risk capacity” – how much risk-return potential is required to achieve an investment goal over time. When time horizons are long, risk capacity – the ability to benefit from risk to provide returns – is high. When time horizons are short, risk capacity is low, as expected withdrawals become imminent.
A diversified portfolio across assets types and geographies
The investment portfolio represents a changing mix of all the major asset classes – UK and global equities, emerging markets, property, UK and global corporate bonds, and government bonds, which together represent thousands of underlying securities. Conveniently as these are all held within a single fund, it’s easy to keep an eye on performance of the portfolio as a whole.
