Should I "hedge" my IRA portfolio with a life cycle / target date mutual fund?

Question

I'm fully contributing to my Roth IRA every year into a brokerage account that is 100% in mutual funds.

I've done basic mutual fund research and picked about 5 different funds that match what would be considered an appropriate allocation for where I am now in my life, and how long till I retire. I plan to re-balance it as necessary down the road.

I'm wondering if it wouldn't be such a bad idea to "hedge" my allocations and mutual fund picks by buying some shares in a life cycle mutual fund(s). These are funds that are designed to be rebalanced by the fund manager as their target date for retirement approaches.

I figure this might be a good corrective strategy to compensate for under performance due to bad picks or slightly-off-percentage-allocations I might make in the long run. Does this seem like a bad idea?

------ EDIT / New Thoughts - Jan 11, 2010 ------

I realized I wasn't taking advantage of my employer's 401(k) matching benefit, so I am going to open one of those up soon (as a Roth 401(k)). I'll designate the entire account to be in a target-date fund. I'll continue to manage my Roth IRA on my own, and let this be my "hedge" for my IRA as described above.

------ EDIT / New Thoughts - July 23, 2010 ------

My fund picks for my own Roth IRA has been consistently performing +1.5% relative to my target date 401(k) fund, over the last 6 months. That feels good =)

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Still, does anybody else have any input or thoughts on this strategy?

Answer 1

First of all, it's great you're now taking full advantage of your employer match – i.e. free money.
Next, on the question of the use of a life cycle / target date fund as a "hedge":

Life cycle funds were introduced for hands-off, one-stop-shopping investors who don't like a hassle or don't understand. Such funds are gaining in popularity: employers can use them as a default choice for automatic enrollment, which results in more participation in retirement savings plans than if employees had to opt-in. I think life cycle funds are a good innovation for that reason.

But, the added service and convenience typically comes with higher fees. If you are going to be hands-off, make sure you're cost-conscious: Fees can devastate a portfolio's performance.

In your case, it sounds like you are willing to do some work for your portfolio. If you are confident that you've chosen a good equity glide path – that is, the initial and final stock/bond allocations and the rebalancing plan to get from one to the other – then you're not going to benefit much by having a life cycle fund in your portfolio duplicating your own effort with inferior components. (I assume you are selecting great low-cost, liquid index funds for your own strategy!) Life cycle are neat, but replicating them isn't rocket science.

However, I see a few cases in which life cycle funds may still be useful even if one has made a decision to be more involved in portfolio construction:

• Similar to your case: You have a company savings plan that you're taking advantage of because of a matching contribution. Chances are your company plan doesn't offer a wide variety of funds. Since a life cycle fund is available, it can be a good choice for that account. But make sure fees aren't out of hand. If much lower-cost equity and bond funds are available, consider them instead.

• Let's say you had another smaller account that you were unable to consolidate into your main account. (e.g. a Traditional IRA vs. your Roth, and you didn't necessarily want to convert it.) Even if that account had access to a wide variety of funds, it still might not be worth the added hassle or trading costs of owning and rebalancing multiple funds inside the smaller account. There, perhaps, the life cycle fund can help you out, while you use your own strategy in your main account.

• Finally, let's assume you had a single main account and you buy partially into the idea of a life cycle fund and you find a great one with low fees. Except: you want a bit of something else in your portfolio not provided by the life cycle fund, e.g. some more emerging markets, international, or commodity stock exposure. (Is this one reason you're doing it yourself?)

  In that case, where the life cycle fund doesn't quite have everything you want, you could still use it for the bulk of the portfolio (e.g. 85-95%) and then select one or two specific additional ETFs to complement it. Just make sure you factor in those additional components into the overall equity weighting and adjust your life cycle fund choice accordingly (e.g. perhaps go more conservative in the life cycle, to compensate.)

I hope that helps!

Additional References:

• Target date fund - Wikipedia
• The Pros and Cons of Target-Date Funds - Investopedia
• Asset Allocation Through ETFs and the Income Glide Path - Seeking Alpha.

Answer 2

I choose lifecycle funds because I am placing faith (perhaps foolishly) that a full time fund manager knows better what to pick than I. The same reason I go with mutual funds in general apply to to why I also have the lifecycle funds. Presently my diversification strategy is really just index funds and lifecycle funds.

The radio advice guy Clark Howard often promotes them.

http://www.wacotrib.com/none/content/shared/money/stories/clark/0601/060425money.html

(I count in the intimidated group)

Answer 3

I like that you are hedging ONLY the Roth IRA - more than likely you will not touch that until retirement. Looking at fees, I noticed Vanguard Target retirement funds are .17% - 0.19% expense ratios, versus 0.04 - 0.14% for their Small/Mid/Large cap stocks.