Should I Invest in a Index Fund or Target Date Funds in 401(k) ?

Trying to make the most of should invest index fund? You are in the right place. Below we break it down in plain English, with practical tips you can actually use.

Key Takeaways

• (adsbygoogle = window.adsbygoogle || []).push({}); I generally don’t pick stocks on my own, except a few I buy for dividend investment.&nbsp...
• I rely on expert fund managers and thus buy mutual funds instead.
• In my employer 401(k) I have options to buy index funds as well as target date funds.

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I generally don’t pick stocks on my own, except a few I purchase for dividend investment. To me direct stock investing is too risky to my limited knowledge about it. I rely on expert fund managers and thus purchase mutual funds instead. In my employer 401(k) I have options to purchase index funds as well as target date funds.

My 401 (k) portfolio is invested in three different target date funds (2030 retirement fund, 2035 retirement fund and 2040 retirement fund) and a couple of index funds, International and large cap index funds.

The ones I don’t have an allocation for is other target date funds and index funds - International equity index fund, Large cap index fund, small/mid cap index fund and bond index fund. Below the snapshot of my retirement fund options. You will have similar ones in your 401 (k) account. If you have it’ll be better if you open your account while reading rest of the post.

Most of us do not look into 401 (k) apart from the net value of it. If you are one of them, have a look in to it, right now. You should find options for both Index funds and target funds. Let me explain what are those funds and how they are different from each other.

What is an index fund?

An index fund is a group of securities, which track the returns of a market index hold securities at the same level as the index. Index funds are structured as mutual funds, unit investment or exchange traded fund. Some of the well known companies that offer these index funds include T.Rowe and Vanguard.

Index funds come in numerous varieties like value stocks and growth stocks. The different varieties of index funds have given investors a lot more freedom to invest. Markets have become more specialized and they are coming up with kinds of index funds.  It is now easier for an investor to make investments in different countries and numerous other different markets because of this.

Management of index funds

The management of index funds can either be active or inactive depending on the company and the indexes. When it is actively managed, it is easier to manage the securities and achieve the objectives of the fund although the cost becomes higher. In the inactive management of index funds, the manager of each portfolio does not figure out the potential risk or reward of every move he makes when he is trading securities. His work is to replicate the index, which has the advantage of reducing the cost.

Cost of indexes

There is no absolute cost of indexes, they may be higher or lower than you expect. Either way, incase you are looking for diversification; the Vanguard 500 may be the kind you want to consider buying. They are generally cheaper, but as has been reiterated before, this is not absolute.

The cost of the most popular index funds is several times higher than what is considered the cheapest of them all in the market-the Vanguard 500 Index Fund Investor Shares. The decision on the kind of index fund you want should depend on the kind of returns you want

What is a Target date mutual fund?

Target date mutual funds are investments based on the number of years remaining till retirement, which is referred to as the target date.

Target date mutual funds have features that make them some of the most attractive ways of investing funds you may have-they do not need active management.  If you want to invest some money for 20 years, you can put it in a target date mutual fund and forget about it, until the 20 years have come and gone. The fund will do all the work and move the fund from riskier investments as your target day approaches.

Target day mutual funds are some of the most attractive investments for people who are retiring since the returns are assured and they do not need personal active management

Target funds have the advantage of needing low minimum investments which will allow you to make diversification depending on what you want. Also, the investor does not always need to make investment decisions during the time he will have invested with the target date mutual fund, which makes it very attractive.

Target date mutual funds are managed professionally, which ensures the safety of your investment and do not need a lot of maintenance from them as well.

The challenges of target date mutual funds

Lack of diversification - this is a big issue when it comes to target date mutual funds, as there is no diversification in the packages that come with the mutual funds. In other words, it operates as a one-size-fits-all system. The target date mutual fund will invest only in funds from a particular type of funds; the kind like Vanguard and Fidelity and none other.

The problem with the lack of diversification is that some people are getting less than they could have if the system had different packages for different types of investments. This is different when it comes to index funds.

High expense ratio - target date mutual funds have a high expense ratio, which may or may not be the case when it comes to index funds. You may have to pay a fee for the management of the mutual funds and in some other cases you have to pay a fee for any underlying mutual funds depending on who you choose to invest with. This will be expensive in the long run. Choose the low-cost providers of target date mutual funds if you want to make this kind of investment.

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Conclusion

1. The options that index funds have for an investor are definitely more than those that of a target date mutual fund, although with index funds you will have greater risk compared to target date mutual funds. Unless your employer retirement plan limits the available funds.

2. With the active management of index funds, you can gain more, but it  requires a lot more knowledge of investment which you should have if you are to get maximum gains from them.

There is no one size fits all financial solution, for some one may work better than the other. Its excellent investment tool for fund managers where investors keep money in for 20 -50 years. This may not be a very good idea for you or I.

The target is so far off that you may not feel the need to evaluate fund performance regularly and thus you may fail to redistribute your money among other funds to maximize your profits and diversify risk. If you can keep an eye of your target date portfolio and notice changes in asset allocation, changes in fund fee structure or changes in manager positions, you can lower the risks of investing in target date funds.

As I learned over the last couple of years, expense ratio is an key factor in choosing one mutual fund over another. The below are the expense ratios of funds my 401 (k) money is invested in.

2035 Retirement fund  - 0.55% of total asset  2040 Retirement fund - 0.55% of total asset  Large cap Index fund - 0.11% of total asset  International Index fund - 0.24% of total asset  Small/Mid cap Index fund - 0.21% of total asset

I am fortunate to have just 0.55% as expense ratio from Wells Fargo target date funds (former Wachovia) . As per Morningstar, average expense ratio for target date funds is 1.08%. So you may be paying much more than I.

Even if the difference in percentage seems minuscule, absolute difference in dollar term gets huge over the years. If we talk about 20 -40 years horizon, a difference to the tune of $5,000 or more can result between total fees incurred by an Index fund and a target date fund on a portfolio of size around $20,000.

My Action plan

I am not touching my portfolio as of now. I don’t have much of an option for index funds anyway. As mentioned earlier, my employer offer only four index funds. I will closely monitor fund performance and adjust allocation accordingly.

Your 401 (k) provider is supposed to send you details on fund fees starting 2012 tax year. Once you receive it, spend some time and determine if your target date fund performance can justify such high fee. A yearly self-review is a good proposition for me. I’ll do that sometime in November/December as part of year-end financial checklist.

One action for you - Read fact sheet/prospectus of all the fund options you have in your portfolio. Available funds should be very limited, it shouldn’t take much of your time reading them.  This exercise will help you get initial grasp over your retirement account. Do give me a shout if you need help.

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Final Thoughts

Before you check out, double-check should invest index fund against current offers and any coupons you can stack. Small habits like this add up to real savings over a year.

Originally published at onecentatatime.com.