Target-date funds, also known as life-cycle funds, are a special breed of balanced fund that may prove attractive to conservative investors and those whose portfolios were mauled in bear markets.
Available in Canada for less than a decade, these products focus on preserving capital. Most of them are mutual funds, although a few companies offer segregated-fund versions to the retail market.
Their maturity dates are meant to accord with important targets in investors' lives, perhaps retirement or the year a child plans to enter university. Over the life of the fund, the asset mix gradually becomes more conservative. Some investors will end up with a small amount of equities in their portfolio, while others will be entirely invested in fixed-income and/or cash.
"Sales ebb and flow with the market," said Eric Frape, Toronto-based Senior Vice President, products and business development with IA Clarington Investments. "But there was a definite pick-up after the market collapse in 2008. This came as no surprise because this is a product for the risk-averse."
In the retail market, $4.45 billion was invested in Canadian TDFs on June 30, 2010, up 5.3% from the $4.2 billion at Dec. 31, 2009, and up by more than 12% from the $3.96 billion on June 30, 2009, Investor Economics reported. Since June 30, 2006, when assets stood at $960 million, TDFs have realized a four-year compound growth rate of 47%.
The current market leader is Fidelity Investments Canada, where TDF assets stood at $1.4 billion on June 30. The company offers both mutual-fund and seg-fund TDFs.
Carlos Cardone, a Senior Consultant at Investor Economics in Toronto, noted that TDFs weathered the 2008 market downturn fairly well. "By mid-2008, there were $3.5 billion in Canadian life-cycle fund drops," he said. "By the end of 2008, the figure was still $3.5 billion, whereas overall mutual fund drops fell by 18% in the second half of 2008."
Management fees of TDFs are comparable to other balanced funds, said Rudy Luukko, Investment and Personal Finance Editor at Morningstar Canada in Toronto. And while the MERs of conventional balanced funds that don't have target dates tend to be consistent over the life of the fund, the MERs of TDFs decline as the fund nears maturity because the equity components decrease in the later years. "The decrease in MERs are one of the product's positive features," Mr. Luukko said.
TDFs are probably more suited to small investors, he added. "These are one-size-fits-all products, and larger investors will want to customize their portfolios."
This one-size-fits-all feature is one of the product's downsides. Critics say TDFs fail to take into account an individual investor's goals, tax situation, estate planning needs and risk tolerance level.
"TDFs simply offer investors an asset mix based on a set time horizon, without regard to liability-matching and other important variables that should define asset mix," said Dan Hallett Director, Asset Management for Oakville, Ontario-based HighView Financial Group. "Whenever you take a short-cut, an easy solution, there are costs to pay, whether direct costs or costs in terms of lost opportunities."
Some TDFs offer investors a high-water-mark guarantee of the highest value the fund reaches. An advisor will need to check the credit-worthiness of the company backing the guarantee, Mr. Luukko said. "A guarantee is only as good as its guarantor."
But, valuable as these guarantees would seem, Mr. Hallett maintains that they "worsen a mediocre product." That's because most TDFs with guarantees are structured in such a way that, in volatile markets, their equities are sold and the assets are parked in fixed-income investments to cover the promised guarantees. As a result, investors will miss out on a rallying market.
"It would make more sense to rebalance in an effort to enhance recovery potential and boost long-term performance," Mr. Hallett said. "By not rebalancing - or worse, monetizing or going all to cash or bonds - protecting the investor becomes secondary to protecting the guarantor's promised capital guarantee. If you have a good asset mix in your portfolio, you don't need a guarantee."
Mark Stewart, Director of product development at BMO Mutual Funds in Toronto, said his company's LifeStage Plus TDFs only gradually shift to fixed income in volatile markets. "It's only when you have a relatively short target date and market volatility that a fund will go to 100% fixed income. However, it's conceivable that, say, the 2022 fund could transition to fixed income sometime between now and its target date. If that happened, the investor could use the assets as the fixed income part of his portfolio, or he could move out of it as there is daily liquidity at the then-current unit price."
BMO's LifeStage Plus funds are currently No. 2 in Canada in terms of retail market assets, with more than $1.1 billion at the end of June 2010.
Mr. Cardone noted that IA Clarington's Target Click funds, which use a derivative trading program to limit downside risk, are one product that doesn't completely eliminate risk to protect its guarantee.
"We invest part of the amount guaranteed in a high-quality risk-free asset - government strip bonds," said IA Clarington's Mr. Frape. "Then we invest half the balance of the fund in a global equity exposure fund that buys futures on global market indices, and keep the other half in a cash reserve. Once a year, we rebalance the cash and equities. If the equities have done well, we'll put more into cash, and vise versa. This asset allocation ensures that we can maintain exposure in a rallying market.
Because TDFs leave the investor with little or no risk at the target date, their critics fault them with failing to take account of different risk-tolerance levels. "Not all investors who are aiming for the same target date are equally risk averse," Mr. Cardone said.
"An investor may think he should ease off on equities as he approaches retirement," Mr. Luukko added, "but the advisor should discuss whether this makes sense in the client's situation. Will his money last him for the next 20 or 30 years? And does he want to leave a sizable legacy?"
But Mr. Stewart said BMO's LifeStage Plus funds are meant to be only one part of an investor's diversified portfolio. "An advisor can add more equities to the aggressive investor's portfolio."
Scotia Asset Management has designed a product that takes investor risk tolerance into account. "Financial planning extends beyond the fund's target date and into retirement," said Neil Macdonald, the company's Toronto-based Managing Director, product development, oversight and communications. "To generate an appropriate level of income, the portfolio has to include some element of risk."
The eight Scotia Vision Portfolios currently have maturity dates of 2010, 2015, 2020 and 2030, with a both conservative and an aggressive option for each target date. "At that target date, Vision Portfolio investors end up with a portfolio that is 70% invested in fixed income and 30% in equities."
For beyond the target date, the company is in the process of developing a perpetual income product that Mr. Macdonald said will generate a stable and predictable income with little risk to capital. It will be available when the 2010 fund matures on Dec. 31.
This past June, the lion's share of TDF assets in the retail market was in mutual fund products, and Investor Economics noted that only 0.5% of total assets was invested in segregated funds. Like their mutual fund counterparts, seg-fund TDFs gradually become more conservative. They also provide the potential for credit-proofing, the ability to name a beneficiary and the death guarantee of all segregated funds.
"They could be of value to business owners who want creditor protection and for investors who have non-registered assets because these assets will bypass the estate through a named beneficiary designation," Mr. Hallett said. "And the death guarantee would give the beneficiary the investor's net deposit in event of a market crash."
Mr. Cardone noted that these insurance features add to the costs of seg-fund TDFs, which carry higher fees than mutual-fund TDFs.