Where investors favor humans over indexes: Target-date funds

In the battle for investors' dollars, the humans have largely lost.

Last year, investors pulled $340 billion out of mutual funds run by managers who are trying to beat the market. Instead, dollars are flowing into index funds, which are content to track the market and charge lower fees for doing so.

Investors are still giving money to active managers in one notable area, though, which also happens to be one of the hottest for retirement saving. Target-date funds offer a simple, do-it-for-you approach to building a nest egg, and one of the fastest-growing providers in the field is American Funds. All its offerings are actively managed, and its target-date funds drew $16 billion in investment last year, according to Morningstar. The only firm to attract more was Vanguard, the giant that helped make index funds the default for many investors.

Target-date funds are built for savers looking to retire in a certain year, and they grow more conservative as the date approaches. The industry calls this shift a "glidepath," and funds do it by moving increasingly from stocks to bonds. American Funds goes a step beyond because it shifts the kinds of stocks and bonds it owns as well, said Bradley Vogt, who leads the committee responsible for its target-date fund offerings, in a recent conversation. Answers have been edited for clarity and length.

Q: Are investors more willing to hire an active manager for target-date funds than other kinds?

A: I think so. In one sense, all glidepaths are active: There's no such thing as the index (of investments designed for someone retiring in 10 or 20 years). Something may be based on passive funds, but it's all actively managed.

Q: So how are your funds different from those built on passive, or index funds?

A: Our feeling is that if you have a 20-year-old and 45- and 75-year-old, they should not only own different amounts of stocks, they should own different types of stocks. Most of the other leading glidepaths out there are pretty consistent, and they're fairly growthy. So the 75-year-old has a smaller amount of the same kind of stocks as a 25-year-old. We think there are better ways to do it.

Instead of the 75-year-old mother-in-law owning Apple, Google, Microsoft and Facebook, just in smaller amounts than her son and granddaughter, our glidepath has the 75-year-old's largest holdings as Verizon, Philip Morris, AbbVie, Coca Cola — higher dividend yield, blue chip, slower moving but lower volatility stocks and hopefully dividend growth.

Q: Your target-date funds started 10 years ago, just before the 2008 financial crisis. What changes have you made to the funds in that time?

A: The crisis happened. We watched that, horrified, and we waited for things to recover. After they recovered, we moved the equity in the retirement phase down a little bit. "Ok, that was a little too volatile for the 70-year-olds." And we watched high-yield bonds be even more correlated with equities than we would have thought and than they had been historically, so we dialed back high-yield bonds as a portion of the fixed income.

And we've added a few funds - the mortgage fund, inflation-protected bonds, International Growth & Income, the Global Balanced fund.

We're architects: We build the house, and we watch it. If there's a big storm, and we see the roof is buckling, we go in and fix the roofline. But it's our next best permanent idea. We're not going to come back in three months and change it.

Q: So will you adjust the roofline again if interest rates jump higher, as some predict, which would hurt the bond market?

A: There is flexibility for some of the funds within the target-dates. But let's say we got in a horrendous market and long-term interest rates went up a lot, and we watched the balanced funds, and they weren't really shifting as much as we would have thought from equities to bonds as bonds went way down, then the committee would need to be willing to say that this is one of the moments to adjust the roofline and take up the fixed-income allocation.

Q: Target-date funds, like most investments, have had strong returns in recent years. The average fund for people retiring in 2045 has returned nearly 10 percent, annualized. What kind of returns can people expect going forward?

A: I think mid-single digits, at these interest rates and market valuations. But (even after taking inflation into account), that will be creating wealth.

Hopefully workers are going to save more, because right now they aren't saving enough. It really needs to be 10, 12, 15 percent of income, not 3, 6, 8.

Q: Is there a wrong way to use a target-date fund?

A: It would be a mistake to get in and out of it and trade it all the time. Occasionally you'll find someone who can do that well and consistently - buy when the market is fearful - but rarely do people do that well.

If you're 20 years old, and you picked the 70-year-old portfolio because you were nervous, that would not be a good decision. We could be in for a horrible couple of decades where that ends up a good decision, but we don't see that.