The Important Differences Between a Mutual Fund and Target Date Fund

Target date funds are great. But they are not the same as a traditional mutual fund. And these differences between a mutual fund and a target date fund are important to understand. And I know I couldn’t have picked one from a hole in the ground a few short years ago.

So let’s dive in.

Examining the differences between a mutual fund and target date fund

Actually wait a second. If you’ve been following the previous few blog posts, my renewed interest in target date funds may seem obvious. But if you haven’t, you may be wondering.

So, for the sake of clarity, I’ve began to ascribe more to the two fund for life portfolio of Paul Merriman and Richard Buck. More on that here. Suffice it to say that one of the funds are a target date fund. So, while I was aware of target date funds, I felt a self-refresher was due.

Ok, now let’s begin.

What is a mutual fund?

A mutual fund is simply a collection of stocks. Stocks being part ownership in a company.

Therefore, mutual funds hold some advantages over individual stocks. First, by holding a bunch of stocks instead of just one, you benefit from diversification. That way, even if one or a bunch of stocks crater, it’s unlikely that all of them in the mutual fund will do the same. So you are still afloat.

Conversely, if you are invested in just a single or a few individual stocks and one goes face up, you are in big trouble.

However, mutual funds vary in the quality, quantity, and category of stocks that they hold. Some contain big company stocks or small company stocks. Others contain tech stocks or healthcare stocks. Still others contain growth or value stocks. Or any sort of combination betwixt and in between.

But there is a problem

The problem is that most mutual funds are actively managed.

This means that essentially there is someone (a fund manager) picking and choosing which stocks to include in the mutual fund and when to sell them to buy other stocks. This fund manager is doing his or her best to pick winning stocks and sell losers so that the mutual fund succeeds.

The issue here is that it have been proven over and over that it is impossible to do this successfully. And despite these findings, mutual fund managers continue to try to do it (because like doctors they have an ego). And they also want to get paid for their hard (but underwhelming) work. Unfortunately, the people who pay them are the people investing in the mutual fund via fees expressed in the fund’s expense ratio.

This leads to the cousin of the mutual fund…the index fund

Since actively managing mutual funds doesn’t work, what is the alternative? The answer is passively investing.

Passive investing is basically the strategy of owning all or most of the stocks in the entire stock market. Since the overall stock market has always gone up over the long term (in the order of 20-50 years), passive investing works over the long term.

Index funds are mutual funds that invest passively. They are mutual funds designed to track a large stock market index, like the S&P 500. Therefore, it contains all of the stocks in that index. And that’s it. No frequent buying and selling of stocks incurring fees and taxes for the investor (you).

That makes index funds much cheaper in addition to performing better than active mutual funds 80% of the time.

TL;DR: Index funds are a type of mutual fund. All index funds are mutual funds. But not all mutual funds are index funds. Index funds are superior to actively managed mutual funds due to lower costs and better longterm performance.

So what are the differences between a mutual fund, even an index fund, and a target date fund?

We now have a good handle on what a mutual fund and an index fund are. Next up, target date funds.

Target date funds are like Cookie Monster.

They gobble up other mutual funds, including index funds. Because they are a fund of funds. How’s that for meta. Put simply, if mutual funds are a big basket containing individual stocks, target date funds are a big basket containing other mutual funds.

Why would we even create such a monstrosity?!

Well, because it turns out that a target date fund does some really cool things.

Let’s take your average investor.

• Let’s say they want to invest passively (smart!) using index funds
• And their desired asset allocation (more on that here, but basically how they split up their investments) is 80% stocks and 20% bonds because they are a young investor and can tolerate investment risk to achieve their desired growth
• But they want their asset allocation to become more conservative (lower stock percentage and higher bond percentage) as they get closer to retirement to favor capital preservation over growth (also smart!)

They have two ways to do this. They can:

1. Buy 2-4 index funds of stocks and bonds in a manner that 80% of their investments are in stocks and 20% in bonds. Then slowly adjust their investments to reach a goal asset allocation of, say, 20% stocks and 80% bonds by the time they retire at age 65

Or, they can:

2. Buy a target date fund with a goal retirement year aligning with their goal retirement (for example, if she is 35 years old now and plans to retire at 65, a 2055 target date fund is perfect). This fund of funds will contain a mix of stock and bond funds that automatically becomes progressively more conservative as their target retirement date approaches. No work required. Pretty nice right!

Pretty nice, right?! That encapsulates the main differences between a mutual fund and its big brother, a target date fund.

Three quick caveats

First, you can check the target date funds are see what the asset allocation starts at and what it ends at to make sure it aligns with your desired risk. And you can always make an adjustment. For instance, if you want to be more aggressive, choose a target date fund with a later goal retirement date. Or choose a closer goal retirement target date fund if you want to be more conservative.

Second, not all target date funds contain index funds. There are target date funds full of actively managed mutual funds. You don’t want these. Because…

Thirdly, there is a cost to target date funds. They require the fund manager to adjust the asset allocation over time. And that requires work (not much, but some). Therefore, the expense ratios of target date funds are a bit higher than the individual funds inside of them. So, if it is full of actively managed funds, these expense ratios can get quite high. Conversely, expense ratios for target date funds full of index funds are still very low. Vanguard target date funds have an expense ratio of 0.08 compared to 0.04 for a single index fund. Be careful that you are choosing a target date fund full of passively managed index funds with an overall low expense ratio.

There you have it!

I really do like target date funds. In fact, one of the biggest changes in my written financial plan (you can find all 7 changes in this post) was to incorporate target date funds into my new investment accounts as part of the two fund for life investing strategy.

If you are looking for a true hands-off investing approach using the principles of passive investing via broad, low cost index funds, a target date fund is a great choice!

Otherwise, here are my Top 11 Ways That Doctors Should Invest!

What do you think? Do you use target date funds? Why or why not? Do you like the concept of a fund of funds? Let me know in the comments below!