Despite a slump, experts high on target date funds

Target date funds were hammered in the third quarter and fared worse then the S&P 500 because of poor performance from international stocks.

Advocates of these popular retirement funds remain hopeful that investors will be patient and won’t dump them based simply on short-term performance.

The average target date fund lost nearly 10% in the third quarter, which is worse than the Standard & Poor’s 500 stock index’s loss of 8.4%. In fact, the miserable performance of international stocks caused the average target date fund to underperform the S&P 500, said Tom Idzorek, chief investment officer and director of research and product development with Chicago-based Ibbotson Associates Inc.

“We suspect the pain target maturity investors have felt this year has many investors truly questioning their target maturity investment for the first time,” he said. “Plan sponsors who moved quickly at the beginning of the year to automatically map investors into a target maturity solution are likely very concerned.”

While it was expected that the target date funds would lose money, Mr. Idzorek was stunned that these funds underperformed the S&P 500 in the most recent quarter, because they tend to perform better in a down market.

The third-quarter average loss of 10% in target date funds trounced the second-quarter average loss of 0.9% and also exceeded the first quarter’s loss of 6.8%.

“The thing that happened this quarter is, international equities was demolished,” Mr. Idzorek said. “It’s extremely unusual,” he said. “Over the last decade or two, investors have been adding international exposure to their portfolios, which I believe to be a very good thing, but in this particular quarter, boy it hurt.”

Target date funds have been heavily marketed to consumers as funds that are simple and are meant to be long-term investments capable of withstanding downturns. These funds were given the nod from legislators to be used as default investments for 401(k) participants who are automatically enrolled.

This means that many investors who may have been automatically enrolled in more conservative funds have been switched to riskier target date funds to help their portfolios grow, and these investors will be stunned at the losses, Mr. Idzorek said.

“I think people are going to freak out,” he said. “I think the people who are really going to freak out are people who were taken from a fixed-income to a target date fund that may have as much as 90% in equities.”

These funds will remain dominant in retirement accounts and are expected to have $1.1 trillion in assets by 2012, up from $277 billion today, according to Boston-based Cerulli Associates Inc.

But industry leaders said that they need to caution clients and 401(k) participants to be patient with these funds and understand that this is an unusual situation and to stay the course because these funds are meant for the long term.

“I think in short-term markets, you can see these things happen,” said Jerome Clark, portfolio manager of Baltimore-based T. Rowe Price Group Inc.’s retirement department. “In this type of market, you’ll have these short-term periods where anything is possible.”

Mr. Clark hopes participants think about these funds as long-term investments and resist the natural urge to pull money out in lieu of safer investments. “What you’d hope is that investors aren’t trying to sell out in this quarter,” he said.

The downturn has been unusual because nearly every sector has been hit, said Don Stone, president of Plan Sponsor Advisors LLC in Chicago, which manages about $6 billion in assets. “Virtually everything is down,” he said. “So bonds haven’t been a safe refuge in this case. In fact, we’ve seen some short-term bonds get killed.”

Mr. Stone believes that the industry will look at these funds more closely when the market slump ends and learn from the lessons to help improve these funds. There will likely be many lessons that can help bolster these funds, he said.

“No one should judge target date funds on the last 12 months,” Mr. Stone said. “In terms of learning how these are constructed, and what works and what doesn’t, it’ll be useful to see what happens. This is really the first test.”

Investors need to be patient, agrees Stace Hilbrant, president of 401k Advisors LLC in Wilmette, Ill., which manages $900 million in assets. “In a lot of cases, people’s allocations have gotten hammered more than the S&P 500, and it’s really been international-small-company funds. A lot of people never expected that level of volatility.”

Investors who bought into target date funds hoping they’d get protection in these types of volatile markets are angry, Mr. Hilbrant said.

“This is unprecedented. It’s a brutally hot topic. People are calling and saying, ‘I thought target funds would help guard us against these huge market fluctuations.’ It’s not true when every asset class has gotten hammered. It’s a perfect storm.”

E-mail Lisa Shidler at [email protected].