I recently received a call from "Russ," a client of mine. He was wondering why the investments he holds at my money management firm have gone up so much more than the money he's entrusted to a major fund broker.
I'd be wondering, too.
That's because, in a year filled with hundreds of 52-week highs and a broad market that climbed roughly 25%, they've managed to "grow" Russ' money all of... 2%?
It didn't take long to find out why.
It's estimated that by 2020, nearly $3.85 trillion will be invested in the same "one-click" mutual fund industry's bestsellers that Russ did: "Target Retirement Funds."
I'm so glad he called.
These "funds of funds" are dangerous. They're far too simplistic, automatically adjusting your investments based largely on one factor: your age. And that just doesn't work anymore.
In fact, these "solutions" are more dangerous than they've ever been...
The Market Doesn't Know - or Care About - Your Birthday
"Target" funds allocate client money to other funds within their respective investment "families," and they do so almost exclusively based on the client's age.
Basically, the older the client, the greater the percentage of the target funds allocated to bond funds rather than equity funds.
That sure sounds good. I mean, who doesn't want an easy retirement solution?
But if successful investing were as simple as knowing your age, then everyone would get it right.
Yet all of the big brokers push these "Target Retirement Funds" now.
Vanguard, Fidelity, T. Rowe Price, Schwab...
And they push them to everyone.
Income investors, retirees, would-be retirees... They even now sell funds that you can tailor to the age when your children will head to college... as if the market cared about our children's ages, too, let alone ours.
Russ found this out just in time...
So Much for "Safety"
My client is 86 years old, and when he told me about his target fund and its underperformance versus my income allocations, I immediately suspected that most of his money was allocated to long-term Treasury and corporate bonds.
Stocks, private-equity funds, business development corporations (BDCs), and other nontraditional income-generating assets have done very well this year.
But bonds, and particularly long-term Treasury bonds, have had a very rough go of it.
For example, the iShares 20+ Year Treasury Bond ETF (TLT), an exchange-traded fund (ETF) that tracks the performance of an index of public obligations of the United States Treasury with a remaining maturity of 20 or more years, is down nearly 17% over the past 12 months.
So much for those "safe" long-term Treasury bonds...
The chart here of TLT shows the bearish trend in this once-hot market segment.
Here's the ProblemOne reason why Russ' target fund has disappointed this year is because these funds follow an easy-to-understand formula called the "rule of 100."
This rule states that if you want to find out how much of your investment capital you should put into equities, and how much you should put into bonds, then subtract your age from 100, and the resulting sum is how much of your portfolio you should have allocated to equities. The rest is what you should have in bonds. So, if you are 86 years old, then just 14% of your money should be in equities, and the rest in bonds.
Yet given how poorly many bond segments have performed in 2013, this rule has been a miserable failure for income investors.
And this "rule" will continue holding you back from achieving your goals.
You can thank a long-term trend of rising interest rates for that...
The Inevitable Shift Has Begun
The inevitable shift toward rising interest rates, i.e., falling bond prices, means many older investors will be grossly over-allocated to one of the worst-performing market segments at the time when they need income most. With bank savings, CDs, and other "safe" investments yielding next to nothing, income investors simply cannot afford to uncritically follow the formulaic underpinnings at the crux of these target funds.
Today, investors need to be more involved, more aggressive, and just plain smarter when it comes to making investment allocations in their income portfolios.
The plain truth is that the new bond landscape demands that your strategy change along with it. In the current environment, you simply cannot buy and hold long-term bond funds, or formulaic target funds, and hope to achieve the kind of yield and share price appreciation required to generate the total return results that many income investors enjoyed during the bond bull prior to 2013.
It's just not enough today to wait around passively for your income holdings to eke out a 2% gain, the way Russ' did. That barely keeps up with inflation, and it definitely doesn't give you the kind of income most of us need to live the way we want to live.
How I Fixed the Problem
In the end, I advised Russ to exit his Total Retirement Fund, and stop relying on outdated allocation strategies, like the "Rule of 100."
After just a few weeks, the move has already paid off for Russ...
More from Robert Hsu:
My Favorite Kind of Money