Pitfalls In Target Retirement Date ETFs

by on November 23, 2011 | Updated November 29, 2011

ETFs have made great progress in simplifying the investing processing; with more than 1,300 exchange-traded products covering just about every asset class, major world economy, and investment strategy, the potential portfolio combinations are endless. For those advisors looking to build a cost efficient, low maintenance portfolio for their clients, ETFs can be quite handy; constructing a strategy that includes every major asset class can be done with just a handful of individual products that result in an effective expense ratio of 30 basis points or less [see 25 Things Every Financial Advisor Should Know About ETFs].

Some of the ETFs out there take this simplicity to the extreme; there are a number of target retirement date ETFs that offer exposure to multiple asset classes within a single ticker, hypothetically allowing investors to buy a total portfolio in one cheap, easy, and liquid transaction. These products are designed to offer a hands-free portfolio that will shift its asset allocation with an investor’s changing risk profile; as the retirement date approaches, the allocation to bonds will climb.

For those fed up with the costly complexity of active managers and sophisticated strategies, the simplified approach offered by target retirement dates might seem refreshing. And these funds can definitely be useful in certain circumstance. But if you’re thinking of embracing extreme simplicity, there are a few things you should know about using target date ETFs as an all-in-one portfolio solution.

1. Lacking Precision

The time until a desired retirement date is, of course, only one factor that goes in to determining the appropriate asset allocation strategy for an investor. It also makes sense to analyze overall level of wealth, risk tolerance, and spending needs / current income sources [see Ten Commandments Of ETF Investing]. Target retirement dates are inherently blunt instruments, whereas each portfolio generally requires extensive customization to address the specific return objectives and risk restraints of an individual.

That doesn’t mean that these products can’t be useful as the core holding in a “core and satellite” strategy. Such a technique might involve holding a significant weight in a target retirement date ETF and using other, more precise funds to fine tune exposure as needed.

2. Layers Of Fees

Target retirement date ETFs are likely to be appealing to investors frustrated with the hefty fees charged by active management and the various expenses that seem to add up when chasing alpha. The simplified, easy-to-understand  structure of an all-in-one fund certainly has some aspects that help to cut down on fees [see How ETF Investors Can Save $415 Million].

But the nature of these products can also result in more expenses than those who take it upon themselves to construct an all-ETF portfolio. That’s because many target retirement date ETFs are structured as ETFs-of-ETFs, meaning that the underlying assets of these funds are other exchange-traded products that in turn invest in individual stocks and bonds. That means another layer of fees; you pay a management fee to your target date ETF, which in turn pays fees to the issuers of the products in which it invests.

Fees for ETFs in the Target Retirement Date ETFdb Category run a wide range; the iShares products are actually quite cheap thanks to a nice fee waiver, while funds from DBX Strategic Advisors–which are not structured as funds of funds–can charge as much as 0.65% in annual management fees. By comparison, our Cheapskate ETFdb Portfolio has a weighted average expense ratio of less than 15 basis points, indicating the potential cost savings by going the “do-it-yourself” route [sign up for a free trial of ETFdb Pro to get access to more than 30 different all-ETF model portfolios].

3. Incomplete, Illogical Portfolios

While the lack of precision and extra layers of fees are certainly worthy of consideration, perhaps the biggest potential drawbacks to target date products is the actual portfolio construction methodology. It’s worth taking a closer look at the composition of these funds, as some of the allocations made–and the asset classes overlooked entirely–might be a bit surprising.

As an example, take a look at the iShares S&P Target Date 2050 Index Fund (TZY). This fund, designed for investors with a target retirement date around 2050, has more than 90% of holdings in stocks–a reasonable allocation given the long time horizon [see TZY Holdings]. But only about 4.3% of the portfolio is allocated to emerging markets through EEM, a small weight considering the supposedly high risk tolerance, long time horizon, and tremendous growth potential for this asset class. When considering that the quasi-developed markets of South Korea and Taiwan make up about a quarter of EEM’s portfolio, the exposure to “pure play” emerging markets is closer to 3%. The BRIC economies of Brazil, Russia, India, and China account for less than 2% of this fund’s total assets. For an investor in it for the long haul, the idea of such minimal exposure to markets expected to account for the lion’s share of global GDP growth in coming decades is a bit puzzling [see Emerging Markets ETFs: Five Factors To Consider].

The light allocations towards emerging markets isn’t the only element that distinguishes many target retirement date ETFs from a balanced portfolio. Some asset classes that may be appealing to investors interested in a long-term, buy-and-hold portfolio are missing altogether. Here are a few asset classes that are nowhere to be found in TZY:

  • International Bonds
  • Canadian Stocks
  • Small Cap EAFE Stocks
  • Small Cap Emerging Markets Stocks
  • Commodities

Some investors might like the strategy used by TZY just fine. But for those who are looking for a truly broad-based portfolio, target retirement dates aren’t going to get you all the way there. These funds can be a good start towards a deep, balanced portfolio. But they’re not a one stop shop; if you really want a well-rounded portfolio, take it upon yourself to do a bit of extra work.

Disclosure: No positions at time of writing.