Under the Hood of “Target Retirement Date” ETFs

by on May 25, 2009 | Updated May 26, 2009 | ETFs Mentioned:

The exchange-traded fund industry has enjoyed explosive growth in recent years due to the significant advantages of these investment vehicles over traditional mutual funds and individual securities. Perhaps most notably, ETFs offer investors a cost-efficient mechanism to gain access to a diversified basket of securities. ETFs allow investors to create a well-diversified investment portfolio by holding only a handful of assets. A relatively new ETF innovation, however, takes this efficiency to the extreme – offering access to a complete portfolio through a single ETF.

Under the Hood

Target retirement date ETFs are the ultimate in a passive, buy-and-hold investment strategy. An investor simply selects the fund that corresponds to his or her intended retirement date (e.g., 2035 fund) and allows the ETF managers to do the rest. I should note that this concept is not altogether new – anyone with a 401(k) knows of numerous mutual funds operating under the same premise - but is a relatively new concept in the ETF industry.

Obviously, an investment portfolio appropriate for a  25-year old professional will not be appropriate for that same investor 30 years later as he approaches retirement. A young investor would likely be heavily exposed to equities, while an investor in his 50s would likely devote a much larger portion of his assets to fixed income investments. As such, target retirement date ETFs are not static, but rather adjust to a more conservative asset allocation as the relevant retirement date approaches.

Let’s take a look at two iShares Target Retirement Date ETFs to understand how these funds change over time:

 S&P Target Date 2040 Index Fund (TZV): This ETF seeks to represent investment opportunity generally available in target date funds through an asset allocation that targets a retirement horizon around 2040. As of spring 2009 (i.e., 30+ years before the anticipated retirement date), TZV’s asset allocation was as follows:

  • 64.8% domestic equities
  • 19.5% international equities
  • 15.7% domestic fixed income

S&P Target Date 2020 Index Fund (TZG): This ETF seeks to represent investment opportunity generally available in target date funds through an asset allocation that targets a retirement horizon around 2020. As of spring 2009 (i.e., 10+ years before the anticipated retirement date), TZG’s asset allocation was as follows:

  • 45.1% domestic equities
  • 12.5% international equities
  • 41.6% domestic fixed income
  • 0.7% domestic real estate

As depicted graphically below, the 2040 fund holds a much higher percentage of equities (84%) than does the 2020 fund (48%). And this makes perfect sense – investors targeting a retirement date of 2020 are likely in or near their 50s. In addition, since there is a shorter time horizon over which they are able to recover value in the event of major losses (like, say, what we’ve experienced over the last 12 months), these investors have a relatively low risk tolerance. Investors targeting a 2040 retirement date, however, are likely in their 30s now and can afford to take on a higher risk profile. This is because these individuals have several years during which they can accumulate savings, and a longer time period over which any adverse movements can be recovered.

As the retirement date approaches, the allocation to fixed income increases

Over the next 20 years, the 2040 fund will gradually shift away from equities and towards bonds, eventually looking very similar to how the 2020 fund looks today.

Funds of Funds

It’s interesting to note the composition of the target retirement date ETFs. iShares’ funds, for example, are almost entirely comprised of interests in other iShares ETFs, including the S&P 500 Index Fund (IVV), Barclays Aggregate Bond Fund (AGG), MSCI EAFE Index Fund (EFA), and S&P Midcap 400 Index Fund (IJH).

Pros and Cons

The most significant advantage of target retirement date ETFs is relatively obvious: investors are able to purchase only one security that adapts over time to fit their circumstances, allowing them to “set it and forget it.” There are, however, also some considerable drawbacks. While investors may be able to keep costs low by limited portfolio turnover, because these ETFs are funds holding other ETFs, there is a double layer of fees. These expenses are relatively low (hence the tremendous popularity of ETFs), but still add up over a long investment horizon. In addition, while age is a significant determinant of an appropriate asset allocation, it is not the only one. Wealth, current income needs, tax situations, and other factors all impact the asset allocation strategy that is appropriate for a particular investor. Since target retirement date ETFs follow general rules to determine their allocation to different asset classes at any given time, they may not meet your optimal allocation strategy.