5.5 Reasons Dividend Stocks Beat Target Date Mutual Funds

Target Date Mutual Funds May Not be on Target.

A fairly recent development in the investment world is the proliferation of target date mutual funds.  These vehicles have become popular in employer provided 401K programs as a means of helping (forcing?) employees to save for retirement.

The belief is that if an employee can invest a minimum of 3% of his or her paycheck simply, painlessly, and automatically, the person won’t object to being helped.  The employer provides a pool of mutual funds structured to optimize the return of the fund based upon a pre-selected investment horizon e.g., 15 years.  If you invest in a target date fund with a 15 year time horizon from the point of this writing, you would probably find yourself investing in a 2035 target date fund since the funds are usually presented in 5 year increments and 2035 is the closest date to a 15 year period.

You could invest in 5-year, 10-year, 20-year, or longer target date funds depending on how long you believe you’ll have to work until retirement, your offspring head off to college, or you have to pay for your daughter’s wedding, whichever comes first.  The target date of the fund determines how aggressively or conservatively your investments are managed. 

Funds with long time horizons are often invested more aggressively by holding large percentages of stock like small cap growth and emerging markets offerings which are normally more volatile than other investment options.  Funds with short time horizons are generally managed more conservatively holding large cap stocks, bonds, or even fair amounts of cash in order to protect investors from market downturns in the short run.

A target date fund is normally a fund of funds.  This means that all its holdings are those of other mutual funds aggregated to produce the appropriate target mix.  For instance, the Fidelity Freedom 2035 Fund is a mixture of at least 29 other funds – growth, index, small cap, bonds, money market, international, and more.  This target date fund has an expense ratio of .74%.  Several, if not all the underlying funds have expense ratios somewhere in the range of .01% to .06% of a percent per fund.  These expenses appear to roughly add up to the .74% ratio specified on the target date fund and eat into your return over the long run.  It should be noted I have a brokerage account at Fidelity and chose the example out of convenience since I don’t have the same visibility to funds from Schwab or Vanguard for instance.  However, other brokerages have target date funds organized in a similar manner to the example used here.

Now that you have a brief summary of target date mutual funds, I’ll explain why I believe a basket of solid dividend paying stocks is a superior investment to a target date mutual fund.

1. Management Fees:  If you purchase and hold individual dividend paying stocks you will pay no management or other expense fees.  Even though the fees associated with target date funds appear small, losing 1% per year over an investing lifetime can result in a noticeable difference.

2. Better Investment Choices: Dividend paying companies with long records of payments and / or dividend increases provide substantive proof of durability, reliability, and profitability.  The firms are publicly traded in which case you can find a plethora of information about the firm and its management team.  Conversely, target date funds are a mixed bag of underlying funds, some of which are new or nearly new.  They have little to no performance track record and frequently no management to be readily investigated.  In other words, investors are left in the dark and told to trust the fund provider.

3. Targets vs Target Dates:  Investments in solid, dividend paying stocks with a long history of payments offer you a snowball’s chance of determining a specific financial target at a specific date in the future and calculating what you’ll need to get there.  Target date funds promise they’re optimizing your returns over a specified period.  Unfortunately, these funds haven’t been around long enough to determine whether or not any of those promises hold water.  What they do seem to accomplish, however, is to ensure a bunch of funds unable to stand on their own merit are packaged in a target date fund to generate a few dollars in fees and potentially give a new MBA the chance to gain experience “managing” a fund. Think of a target date fund like cable TV.  You have to buy a bundle of channels, most of which you don’t like, watch, or know anything about, but have to pay a few bucks for in order to get those handful of channels you watch regularly.  The same principle applies with target date funds.

4. Investment Control: When selecting individual dividend paying stocks, you get to make the selections.  You aren’t arbitrarily required to buy a cable TV style package of stocks or mutual funds you don’t want in order to get the one or two you do.  As an individual stock holder, you also get to determine how long those investments are held.  When it comes to mutual funds, many have fairly high rates of investment turnover within the fund.  Think turnover greater than 50% annually.  That’s a lot of churn generating fees for someone other than you.

5. Real Compound Growth:  If you’ll recall my post on 7 Reasons Dividend Stocks Beat Real Estate Investing you’ll understand what I mean by real compound growth.  When dividend payments from individual stocks are automatically reinvested, you are issued additional shares of the firm.  Over time the percentage of the company you own as an investor actually grows, all other factors being equal.  In target date funds, any dividends paid to the underlying funds may result in changes to the NAV or Net Asset Value (valuation metric) for the fund and that’s it.  You don’t benefit from an increased ownership stake in anything.

As with other discussions, here are a few items to ponder.

0.5 Availability: In many 401K offerings, you aren’t given the chance to invest in individual stocks.  You may have no choices outside a basket of mutual funds.  In these situations, I’ve tried to stick with stock index funds like an Equity Index 500 or Russell 2000 index fund. 

These index funds offer greater visibility to the underlying holdings allowing me to see where my money’s going.  Also, a good equity index fund will have among the lowest management or administrative fee structures available.  Consequently, gains, if any, aren’t siphoned away by the transactions crowd over time at the same rate as target date funds.

Target date funds truly provide a “set and forget” offering.  However, I’d rather not set and forget my money then hope it’s where it needs to be when I’m ready for it.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.