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 investment 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 index.
Here’s a closer look at the key differences between target date funds and index funds to help investors understand which is right for their portfolio.
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 a hands-off approach to saving for retirement. In a way, they’re like a retirement plan inside a single investment vehicle. Investors do not have to choose the funds 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 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 |
|---|---|
|
• Reallocated automatically. Portfolios typically become more conservative as a target date approaches. • A fund of funds that provides investors with diversification and a single set-it-and-forget-it solution to retirement savings. |
• Passive management translates into lower fees. • Designed to track an index, such as the S&P 500, and provide returns similar to the movements of the index. • Allows investors more flexibility in choosing the funds in their portfolios. |
Target-Date Funds
A target date fund is a type of investment that holds a mix of different mutual funds, usually including 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 financial security 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 high-risk, high-reward investments into low-risk, low-reward investments, by shifting a greater proportion of its holdings into bonds to help preserve wealth, for example.
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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 or those who don’t want to design their own portfolios or those who find a hand-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. • Diversification through a basket of mutual funds. • 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. |
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, such as the S&P 500 or the Bloomberg Barclays Aggregate Bond Index.
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 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. Also, because they track an index, which updates its numbers constantly, it is unlikely fund managers will be blindsided by something they were unable to anticipate.
Index funds also potentially offer better returns than their actively managed counterparts, especially after factoring in fees.
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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, fund managers will hang on to them even if they are performing poorly. In actively managed funds, fund managers can swap out slumping securities in favor of those that are outperforming.
In fact, by design, index funds rarely beat the market. Remember they are built to match the returns of an index, not go beyond them.
Here’s a look at the pros and cons of index funds at a glance.
| Pros | Cons |
|---|---|
|
• Diversification through a basket of securities that tracks an index. • Transparency. • Lower fees. Passive management makes it cheaper to operate funds, which results in lower management fees passed on to investors. • Steady gains and potentially better returns than actively managed funds. |
• Lack of flexibility. Index fund managers follow stricture mandates about what can and can’t be included in the fund. • Index funds do not typically outperform the market. |
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 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.
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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 circumstance 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 right 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. These investors may not want to or know how to pick funds themselves.
You can also save for your retirement without using index funds or target-date funds. A great way to start is via the SoFi Invest online brokerage. You can use it to invest in exchange-traded funds, stocks, or initial public offerings.
Photo credit: iStock/Ridofranz
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