Thursday March 16, 2006
Are "Life Cycle" Funds A Good Investment?
More and more money is moving into "life cycle" funds, Wall Street’s latest investment fashion. What are "life cycle" funds? And are some life cycle funds actually better than others?
A "life cycle" fund is a fund that automatically adjusts its allocation between stocks and bonds as you get closer to a specific target date — usually the date of your retirement. Suppose you plan to retire in, say, nine or ten years. You would shop for a life-cycle fund with a 2015 target date. And the fund would automatically and gradually move your holdings year by year from larger positions in stocks into larger positions in bonds and cash.
You might start off holding 75% in stocks and 25% in bonds right now, but end up with the reverse — 75% in bonds and money market and only 25% in stocks — by your target date.
The idea underlying "life cycle" funds is that you will want less risky investments as you near retirement. Because you will have less time to recuperate any losses you might sustain, most financial planners insist that you need more conservative investments — specifically, more investments in bonds, money market, and cash — as you get closer to your retirement date.
So "life cycle" funds do the allocation work for you. Once you put your money in, the fund automatically and gradually moves you into larger and larger positions in "less risky" investments each year. The principle is great. The convenience is unbeatable.
Many fund families offer these funds with "target dates" that are usually spaced five years apart.
Okay. Are some of these funds better than others?
I looked at the performance of the life cycle funds of three fund families — American Century, Fidelity, and Vanguard — in December, 2005 and again in March, 2006. I found several key differences.
Difference #1: Stock Allocations. Among the three families, Fidelity tended to have higher allocations in stocks. For example, Fidelity 2035 Fund [FFTHX] put approximately 82% of your money into stocks [as of mid-March, 2006]; while Vanguard [VTTHX] and American Century [ARYAX] put 76% into stocks instead. That’s a substantial difference.
Stock Allocation Comparison [Percent in Stocks]
| Target Date >> | 2005 | 2015 | 2025 | 2035 |
|---|---|---|---|---|
| American Century | — | 52% | 64% | 76% |
| Fidelity | 45% | 58% | 73% | 82% |
| Vanguard | 30% | 45% | 57% | 76% |
Difference #2: Investment Content. All three families actually invest your money in different mixes of their other stock and bond funds. For example, Fidelity’s 2025 target-date fund [FFTWX] invests 72.9% in stocks by placing your money into a number of its actively managed funds: the Fidelity Growth & Income fund, the Fidelity Equity-Income Fund, Blue Chip Growth Fund, etc. Vanguard’s 2025 Fund [VTTVX] places 56.7% of your money into stocks — but specifically invests in a variety of Vanguard domestic and international indexes. So you get a lower amount of stock exposure with Vanguard [57% in stocks and 41% in bonds versus Fidelity’s 73% stocks and 21% bonds], but you get extremely broad diversification via Vanguard’s indexes.
Difference #3: International Exposure. Of the three families, only Vanguard’s life cycle funds give you international exposure. Vanguard’s 2025 fund [VTTVX], for example, invests about 12% of your money into non-U.S. equity indexes. The Vanguard 2035 fund [VTTHX] invests about 15% into international equities.
Difference #3: Performance. Because of their generally higher stock allocations, Fidelity’s life cycle funds have tended to produce higher 12-month returns when compared with Vanguard and American Century judging from my recent samples. For example, the rolling 12-month return of Fidelity’s 2035 Fund was 12.8% on March 14, 2006. By comparison, Vanguard’s 2035 Fund produced a 9.78% return and American Century’s a 9.66% 12-month return for the same period. That’s a substantial performance difference for Fidelity.
My own take is that most investors probably need substantially more stock exposure than the amount suggested by "conventional wisdom". Retirees can expect to lead increasingly longer life spans. And as life spans extend, the need for post-retirement income becomes larger and larger.
So in my view, most people should not dramatically cut back their stock exposure just because they near retirement. Yes — you do want conservative, "less risky" investments as your tolerance for losses declines. But "less risk" and "loss avoidance" have a more to do with the quality of the investments you make — not simply your birth date.
When you consider life cycle funds, look for two things: (1) larger [that is: at least 45%] exposure in stocks [like Fidelity’s funds] whatever your "target date", and (2) broad international exposure as well. Having "non-U.S." investment exposure will enhance your diversification and reduce risk. International exposure is an important ingredient.
That leaves you with three options. One, you can use a core life-cycle fund like Fidelity’s but complement it with additional international stock exposure. You can put 90% of your money in a Fidelity life cycle fund and 10% in, for instance, Vanguard’s VGTSX Total International Index. That will give you very high stock exposure and reasonable international diversification.
Two, you can use a Vanguard life-cycle fund as your core [putting, say, 90% of your investment into it], but complement it with some additional stock exposure in a broad fashion [say 10% into VTSMX Vanguard’s Total Stock Market Index].
Or, three, you can do you own allocation using a variety of domestic and international funds. That, frankly, is best since most of the "packaged" life cycle funds do not give you adequate international and equity exposure.
The fundamental issue is one of risk and reward. Do you need to cut your stock exposure as you age? And, if so, do you want an automatic investment fund or do you want to make gradual allocation shifts, yourself?
If you don’t have time to select funds on your own, a mix of Fidelity and Vanguard life-cycle funds can be a great help. Better yet, build your own "life cycle" portfolio: look for equity funds that invest in income-oriented or dividend-paying stocks [to offset speculation risk] and do the allocation work yourself. Aim for 60% U.S. stock exposure and 40% international stock exposure. And keep your bond exposure primarily in short-duration securities so you are not taken by surprise if interest rates shift up.
A "do-it-yourself" mix will work best. But if you are conservative and have no tolerance for losses, then a Fidelity/Vanguard "life cycle combo" may be satisfactory.
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