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Target-date funds and index funds are two common investment vehicles for individuals investing for retirement. Investors may see one or both of these types of investments as options in their 401(k) or other workplace retirement fund. Target-date funds offer a sort of set-it-and-forget-it approach to investing typically tied to an investor’s timeline, while index funds include a basket of investments corresponding to an underlying market index.
Understanding the key differences between target date funds and index funds can help investors understand which option may be a fit for their portfolio.
Key Points
• Target-date funds provide a set-it-and-forget-it investment strategy, ideal for investors looking for a more hands-off approach.
• These funds automatically reallocate assets to become more conservative as the investor’s retirement date nears.
• Index funds offer broad market exposure and are generally passively managed, resulting in lower fees.
• Investors in index funds may benefit from simplicity and cost-effectiveness, which may make them suitable for beginners.
• Key considerations when choosing between a target-date fund and an index fund include personal financial goals, risk tolerance, and the trade-off between control and convenience.
Target-Date Funds vs Index Funds: A Comparison
Target-date funds and index funds are both common ways for investors to save for future goals, especially retirement. Target-date funds offer what can feel like a hands-off approach to saving for retirement. Investors choose a target fund with a date that’s closest to the year they plan to retire.
Over time, these funds automatically adjust their asset allocation, typically becoming more conservative as the investor gets closer to retirement. Investors do not have to choose the assets held by target date funds or reallocate the fund as it nears its target date.
Target-date funds may include index funds. Index funds track specific market indices and typically perform in line with the broader market.
Here’s a quick look at the main differences between these two types of funds.
| Target Date Funds | Index Funds |
|---|---|
|
• A fund that provides investors with a set-it-and-forget-it option to retirement savings. • Reallocates automatically. Portfolios typically become more conservative as a target date approaches. • May have higher fees if they are actively managed. |
• Designed to track an index, such as the S&P 500, and seek to achieve returns similar to the movements of the index. • Allows investors more flexibility in choosing the funds in their portfolios. • Passive management typically translates into lower fees. |
Target-Date Funds
A target date fund is a type of investment that holds a mix of different funds, which may include mutual funds, such as stock and bond funds. When choosing a target date fund, investors must decide on a target date, often offered in five-year intervals and included in the name of the fund and corresponding with the year in which they want to retire. For example, someone in their early 30s might choose a target date of 2055 with a goal of retiring around age 65.
You could, in theory, use target date funds to save for any point in the future. However, they’re a popular type of vehicle for saving for retirement and often appear on the menu of investments available to employees through their 401(k)s.
As an individual nears their target date, the fund automatically rebalances from higher-risk, higher-reward investments into lower-risk, lower-reward investments. For example, the rebalancing might include shifting a greater proportion of its holdings into bonds to help preserve accrued increases in a portfolio’s value.
Pros of Target-Date Funds
There are several reasons investors might choose a target date fund.
First, they essentially provide a ready-made portfolio of diversified stock and bond funds, making it easy to save for retirement. This may appeal to beginner investors, those who don’t want to design their own portfolios, or those who find a hands-on approach to researching and choosing investments difficult.
Additionally, target-date funds provide automatic rebalancing. As the market shifts up and down, different investments may move off track from their initial allocations. When that happens, the fund will rebalance itself so that the allocation remains in line with its original allocation plan. The target date fund also automatically shifts its allocation to more conservative investments as the target date approaches.
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Cons of Target-Date Funds
Investors who want more control over their portfolios may not like target-date funds, which don’t allow investors any control over their mix of investments or when and how rebalancing takes place.
Target-date funds build portfolios using a variety of investments. Some may use index mutual funds that come with relatively low fees. Others might use managed mutual funds, which may come with higher fees. It’s important to look closely at target-date fund holdings to understand what types of fees they might charge.
Here are the pros and cons of target date funds at a glance.
| Pros | Cons |
|---|---|
|
• Ready-made portfolio. • A basket of mutual funds may help provide some diversification. • Automatic rebalancing, including a shift to more conservative assets over time. |
• Lack of control over investments and when portfolio is rebalanced. • Potentially higher fees for funds that hold managed mutual funds. |
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Index Funds
An index fund is a type of mutual fund or exchange-traded fund (ETF). It’s built to follow the returns of a market index, of which there are many.
These indexes track a basket of securities meant to represent the market as a whole or certain sectors. For example, the S&P 500 is a market capitalization weighted index that tracks the top 500 U.S. stocks.
An index fund may follow a market index using several strategies. Some index funds may hold all of the securities included in the index. Others may include only a portion of the securities held by an index, and they may have the leeway to include some investments not tracked by the index.
Because index funds are attempting to follow an index rather than beat it, they don’t require as much active management as fully managed funds. As a result, they may charge lower fees, making them a low-cost option for investors.
Index funds are popular choices for retirement savings accounts. They are designed to offer diversification through exposure to a wide range of securities, they’re easy to manage, and they offer the potential for steady long-term growth.
Pros of Index Funds
Low fees and full transparency are among the benefits of holding index funds. Investors can review all of the securities held by the fund, which can help them identify and weigh risk.
Historically, index funds have also potentially offered better returns over the long term than their actively managed counterparts, especially after factoring in fees.
Recommended: Actively Managed Funds vs. Index Funds: Differences and Similarities
Cons of Index Funds
Some of the drawbacks to index funds include the fact that they are often fairly inflexible. If they follow an index that requires them to hold a certain mix of stocks, they decline in value when the market does.
In addition, because many index funds use market capitalization weighting, the funds can be concentrated in a few large companies with a higher market capitalization. If those few companies don’t perform well, it can affect the entire fund’s performance.
Here’s a look at the pros and cons of index funds at a glance.
| Pros | Cons |
|---|---|
|
• Designed to offer broad exposure through a basket of securities that tracks an index. • Transparency. Investors can review the holdings in the fund. • Lower fees. Passive management typically makes it cheaper to operate funds, which results in lower management fees passed on to investors. • Potentially better returns than actively managed funds. |
• Lack of flexibility. There may be strict mandates about what can and can’t be included in the fund. • A few companies with a higher market capitalization may have a significant impact on a fund’s performance. |
Index Funds for Retirement
You can use index funds to build a retirement portfolio as well as to save for other goals. If you’re using them for retirement, you may want to consider a mix of index funds covering a range of asset classes that can provide some diversity within your overall portfolio. Unlike a target-date fund, if that allocation strays from your goals, you’ll need to handle the rebalancing on your own.
The Takeaway
Index funds and target-date funds are funds used by retail investors for different purposes. Investors choosing between the two will need to consider their personal financial circumstances and needs. Index funds may be an option for investors looking for passive, long-term investments that they can choose based on their own goals, risk tolerance, and time horizon. They may also be a choice for beginners who are looking for simple, low-cost investment options.
Target date funds, on the other hand, may be another option for long-term investors who do not want to have to rethink their portfolio allocations on a regular basis.
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FAQ
Are target-date funds or index funds better?
Whether index funds or target-date funds are better depends on an investor’s circumstances and goals. Index funds track a market index, offer broad market exposure, and are generally simple, low-cost investments. Target-date funds, frequently used for retirement savings, offer a hands-off investment approach tied to an investor’s timeline, automatically adjusting the asset allocation. An investor can weigh the pros and cons of both options to determine which is right for them.
What is the downside to target-date funds?
A downside to target-date funds is that investors don’t have control over the mix of investments in the funds or when rebalancing takes place. These funds may also come with higher fees.
Are index funds good for beginners?
Index funds can be a good option for beginners because they are a simple, low-cost way to hold a mix of securities that track a particular market index, such as the S&P 500.
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