Index Funds vs. TDFs: Which Is Right for Me?
Making investment decisions for your 401(k) can be a little confusing — and intimidating. One common question many retirement investors face is whether to choose an index fund or a target date fund (TDF).
A closer look at the pros and cons of these investment vehicles can help you determine whether an index fund or a TDF is the right move for your portfolio.
Index Funds
Index funds are collections of investments that track a specific market index. For example, there are funds composed of all the stocks listed on the S&P 500. With an index fund, you get a share of everything listed on the index. In addition to stock funds, there are also bond index funds. It’s possible to put together a retirement portfolio using just stock and bond index funds in a mix that makes sense for you. However, you’ll need to rebalance your portfolio as you approach retirement.
Advantages of Index Funds
- Instant diversification: You have exposure to all the investments on a specific index and you can get access to broad market trends.
- Low cost: Index funds tend to have lower expense ratios, allowing you to see higher real returns over time.
Disadvantages of Index Funds
- Less exposure to alternative investment strategies: Returns track the index for better or worse. Index funds can’t respond to changing markets so there isn’t an ability to react to short-term market fluctuations or more lasting trends.
- Risk of losses near retirement: While stock market indexes have historically increased over time, you’ll need to monitor them more closely as you approach your retirement date so that a market correction doesn’t derail your plans.
TDFs
Target date funds also offer access to diverse assets with one investment, including stocks, bonds and other asset classes in one instrument. However, a TDF is professionally rebalanced periodically to reflect your glide path as you approach retirement. The asset allocation of stocks versus bonds held in the fund changes over time without the need for you to do anything.
Advantages of TDFs
- Set it and forget it: Simply set your target retirement date, and the fund does the rest. You don’t have to think about asset allocation as you approach retirement.
- Professional management: Rather than passive management that comes with index funds, investment professionals manage your TDF and make adjustments as they deem necessary.
Disadvantages of TDFs
- No differentiation among investors: Most TDFs are a one-size-fits-all solution based on time horizon until retirement, rather than looking at other aspects of risk tolerance and retirement planning. An exception to this, however, is the flexPATH TDF, which offers a conservative, moderate and aggressive glide path tailored to investors’ risk tolerance.
- Potentially more expensive: Some TDFs come with higher fees. These can erode your real returns, leaving you with a smaller portfolio balance over time.
Decisions, Decisions
Whether index funds or TDFs are right for you depends on your risk tolerance and your long-term goals. For some retirement investors, it can make sense to pay slightly higher fees for the convenience of automatic rebalancing and diversification. On the other hand, index funds can be cost-efficient as long as you’re willing to manage rebalancing on your own.
Contact your WellCents financial professional to discuss whether you want to incorporate index funds or a TDF into your retirement strategy — and to help determine what makes sense for you.