Target date funds
Question: I always hear you guys say to diversify your retirement funds. It makes sense and I'm on board with that. However does putting all your funds in a target date fund qualify for this? It does spread things around but it is in all one fund. John, Mooresville, NC
Answer: I think you're okay. I'm assuming the fund is in a retirement savings account (although my thoughts apply even if it isn't).
First, let's look at target date funds (sometimes called lifestyle funds) for those who aren't as familiar with them. The fund is designed to offer the investor "asset" diversification. A target date fund automatically resets the employee's portfolio according to some preset formula. The basic idea behind target date funds is that younger workers will own a mix of investments heavily weighted toward equities, international stocks and other risky assets and as they age the more conservative parts of the portfolio grows, such as cash and bonds.
That's the basic idea. One problem with these funds is that they often hold a considerable amount of equity well past the retirement date, on the theory that retirees will need the boost from equity returns throughout retirement. It's more risk than many retirees want.
For example, the average target-date fund with a retirement target of 2010 had half its portfolio in equities going into 2008. Fund values subsequently fell 23 percent on average during the bear market. However, the subsequent spate of bad publicity has pushed the industry toward a more conservative portfolio construction or at least making the risks more apparent. In other words, not all target date funds are the same. Fees vary considerably. Some are more diversified than others. Some keep a substantial portion of the portfolio in stocks even after the retirement target date and others don't. You'll want to shop around.
As for the lack of institutional diversification, I'm not all that concerned. The most important factor is that your money is invested in the actual securities. The money managed by the mutual fund company is kept in separate trust accounts at a custodial bank. So, even if the mutual fund company got into trouble you would still own the actual securities in segregated accounts held at another institution. It's strong firewall.
Still, I do like diversification. My guess is that you'll probably end up diversifying into other financial institutions and their products as you change jobs and as you look for other places to save money other than your 401(k).