Target-date mutual funds take much of the guesswork out of investing.  With target-date funds, investors don’t have to decide what balance to strike between stocks or bonds—the fund makes that determination. Furthermore, as the fund reaches its target date, and afterward, its portfolio theoretically assumes less risk.

The simplicity of these vehicles led many investors to forego the traditional portfolio mix of individual stocks and bonds. Instead, many parked their assets in a single target-date fund and left the legwork to fund managers. The US Dept of Labor went so far as to recommend target-date funds as the default investment option in 401(k) plans.

Unfortunately, target-date funds have disappointed investors. During the 2008 financial crisis, many near-dated target-date funds sunk like stones; some lost as much as 40 percent of their value. This outcome confounded investors’ expectations for target-date funds; these investments were supposed to reduce risk as they approached their target date. Instead, they grew riskier to hold as the crisis deepened.

There were two reasons for this reversal of fortune for target-date funds. First and foremost, in 2008 investors fled en masse to safe-haven investments, making Treasury bonds almost the only asset class to post gains. If you weren’t entirely in Treasuries, you most likely lost money that year. This underperformance across sectors hurt the perception of target-date funds among the investing public.

Second, asset managers had different approaches to managing target-date funds. Some managers believed these funds should reach the most conservative point of their arc at the target date, and ran their charges as if they were targeted-risk funds. Other managers took an approach that is better characterized as “life cycle investing.” Those funds grew more conservative as investors aged and wouldn’t reach their most conservative allocations until about 15 years after the target date.

If investors didn’t understand the nuances of these investment strategies, they experienced some nasty surprises in 2008 and 2009.

The Securities and Exchange Commission has proposed new rules that would make it easier for investors to understand target-date funds. Those rules would require fund managers to provide projections for their funds’ asset allocations at various points in the life of the fund. These rules also call for a clearer explanation in the fund’s prospectus of how that fund will be managed in respect to its target date. Additionally, a description of the possible investments that a target-date fund may make will appear after the first mention of the fund’s name in all of its marketing materials.

These clarifications will help, but many investors will surely be left wondering which target-date fund is suitable for their investment goals.

How to Pick Winners

The first step to picking a target-date fund is to understand how the fund’s asset allocation strategy will evolve—information that’s available in the prospectus. This can be achieved by simply reading the fund’s prospectus. If you have any questions after reading the prospectus, telephone the fund company. If you don’t understand how your risk exposure will change over time, you may never achieve your long-term investment goals.

Decades of research have demonstrated that costs are a significant drag on a fund’s performance—funds must generate higher returns to compensate for higher costs. A cheaper fund is always better than a more costly offering. As a rule of thumb, only consider funds with expense ratios lower than 0.70 percent.

Investors must also examine the target-date fund’s holdings. Unlike traditional funds that invest in individual stocks and bonds, target-date funds are structured as “funds-of-funds”—mutual funds that invest in other mutual funds. Just as you might research the companies in a mutual fund’s portfolio, you’ll want to be sure that the target-date fund’s holdings are solid investments. One recent trend is the inclusion of commodity, real estate and alterative strategy funds in the target-date fund’s portfolio. That can add diversification to the target-date fund, but be sure that the weighting of those asset classes doesn’t climb above 10 percent.

Be mindful of how many funds your target-date fund holds in its portfolio. Too few funds, and your target-date fund won’t be well diversified; too many funds will result in redundancies and higher expenses. Generally, about 15 underlying funds are enough to provide diversification without much duplication. Additionally, in most cases it’s better to invest in a target-date fund that builds its portfolio around index funds rather than actively managed funds. That’s because index funds sport lower expenses.

Realistic Expectations

Realistic expectations are key to investing with target-date funds. These funds specialize in prudently allocating assets; their performance will never keep pace with the new investment flavor of the month. Nor do they provide the stability of the best value funds; target-date funds can suffer difficult months or years. “Realistic Expectations” shows how funds with different target dates have performed and how much risk they entail, as measured by standard deviation.

Target-date funds aren’t a panacea for every investor’s woes. But they can be excellent investments for those who know what to expect.