Lifecycle Funds from TD Ameritrade for Retirement and College Planning

One challenge in planning for retirement, or any goal with a particular date, is how to invest to meet that goal. How much should an investor have in different types of investments? How much in stocks, bonds, and other asset classes? How should the proportions change over time? For example, a person with one year to go on his retirement may wish to have more of his portfolio in fixed income than equities, as it provides more certainty about the future value of the investment.

Recently, many mutual funds have set up lifecycle or target date funds that are designed to assist people in meeting investment goals by a particular date. They tend to have more of the assets in equities when the target date is far away and reduce that amount, substituting fixed income, as the date approaches. Now, TD Ameritrade has put together a family of ETFs that allow investors to make lifecycle investments at a lower cost -- 65 basis points -- than the lifecycle mutual funds.

The TDAX Independence Exchange Traded Funds series from XShares Advisors provides investors with 5 target date funds -- 2040, 2030, 2020, 2010, and its Independence in Target Fund (designed for a near term target. The table depicts the funds asset allocations at inception and target date.



Assets will be adjusted as the target date approaches, from a more aggressive allocation that emphasizes equities to a more conservative allocation, that emphasizes fixed income. Each portfolio is designed to have 89%fixed income, 3% international equity, and 8% domestic equity on the target date. After reaching the target date, the allocation is adjusted over 5 years to 68% fixed income, 8% international equity, and 24% domestic equity. The table below shows the starting and ending breakdowns for each fund.

What the experts say
In a recent article, noted retirement experts Zvi Bodie and Jonathan Treussard of Boston University discussed how appropriate Target Date Funds were for people in planning their retirement.2 They note that many people in self-directed retirement plans, such as IRAs and 401ks may not know enough about investing to choose the right funds, or may not put in the time and effort to find them. Simple target date strategies may be an improvement over many of the choices made by people who do not know that much about planning. (And let’s not forget the fact that employers do little to educate their employees in this area). Bodie and Treussard observe that there are certain people for whom a target date fund is a good solution. Others, however, may be more risk averse or have a higher exposure to market risk through their means of earning an income, and may benefit more from a investments that have greater safety and are matched to their retirement date, such as Zero Coupon TIPS (Treasury bonds with prices that adjust upward for inflation) with a maturity date matching their retirement. Investors need to consider their risks when choosing retirement fund options.

Passions run High on Indexing

It was quite a surprise for the debate over fundamental indexing vs. market-cap indexing to make it to the front page of the New York Times Business Section, but it has. In an article entitled, Passions run High on Indexing, by editor Joe Nocera, that appeared in the 17 May 2008 issue of the New York Times.

While few people can probably get excited about how indices weight their components, it matters to people in the ETF industry, because ETFs make money simply by having more assets under management. Any fund that has a secret formula for providing better returns may attract more investors.

The basic premise behind fundamental indexing, as proposed by Robert Arnott of Research Affiliates who has created the fundamental indices that underlie many Powershares products. His basic contention is that market cap weighting overweights the overweighted and underweights the underweighted, leading to underperformance in the long run.

His opponents claim that his system is not indexing. This is incorrect. It is simply an alternate form of weighting. Indexing is simply tying an investment to a particular index. The debate has gotten highly mathematical and arcane. Only time will tell who is right. However,
Arnott should not be counted out, as there is no doubt he is a very smart man -- he collaborates frequently with Peter Bernstein of Against the Gods: The Remarkable Story of Risk fame.

The other problem with many of his opponents' argument, is they see the S&P 500 as the “market.” This is not correct, as the S&P is not some unbiased measure of the “market” but 500 large cap stocks selected by the index committee at Standard & Poor’s according to criteria known only to themselves.

Leveraged ETFs -- Twice the Risk but not twice the return

A recent article in the Journal of Financial Planning. raises significant concerns about the use of leveraged ETFs -- those that multiply an index to increase the returns.

"Leveraged ETFs: A Risky Double That Doesn’t Multiply
by Two" by William J. Trainor, Ph.D., CFA and Edward A. Baryla, Jr. Ph.D.
Journal of Financial Planning, May 2008. pp 49-55.

This article investigates the performance of leveraged funds, those funds that are designed to multiply the return of a particular index. However, the ways the funds appear to work, means that the funds have some extra risks associated with them. The study comes to some important conclusions:

While leveraged ETFs can multiply index returns on a day-by-day basis, long run returns can not be multiplied by the same ratio because f a phenomenon known as the constant leverage trap and the lognormal nature of continuously compounded returns.

While many leveraged ETFs meet their specific daily targets, there is quite a bit of volatility related to meeting their targets on any particular day.

After using Monte Carlo simulations, the authors found that a typical 2X leveraged fund magnifies the index return only 1.4 times on an annual basis, for holding periods up to ten years. But the risk, as measured by standard deviations, stays double, or in some cases even quadruples in cases of extreme negative returns.

The authors compare leveraged ETFs to buying an index fund using a margin account and shows that the leveraged ETFS are superior in the long term due to their lower cost.

They caution long term investors to be wary of the risk/return tradeoff of leveraged ETFs, given that these types of funds can have extreme swings in value. However, they note that leveraged ETFs could be useful for short term investors/traders who are willing to take the risk and are taking a distinct position on the market.