What it means
Investors often find it hard to build a portfolio themselves. A target risk fund does this for them, offering a ready-made mix suited to a comfort level with risk.
A conservative fund might hold mostly bonds, while an aggressive one holds mostly shares, and a moderate fund sits somewhere between the two. The key feature is that the risk level stays roughly constant.
As markets move, the proportions drift from the target, so the manager sells assets that have risen and buys those that have fallen to bring the mix back. This is called rebalancing, and it keeps the fund from becoming riskier than the investor chose.
Some versions go further and aim for a target level of volatility, meaning the size of the ups and downs in value. When markets become more turbulent, the manager reduces share holdings, and when they calm, increases them.
The label is the same, but the method is more active. Target risk funds are common in workplace retirement plans, where they give employees a simple choice of risk level.
Fees are an important consideration, because a fund that invests in other funds may charge a second layer of costs. The investor should also check that the risk label matches the actual holdings.
The main limitation is that the fund does not know anything about the investor's age, income or other savings. Someone close to retirement who selects an aggressive fund may face large losses at the wrong time.
The choice of risk level still needs to be made thoughtfully and reviewed. It also helps to know what the fund is measured against.
Many are compared with a blend of share and bond indices in the same proportions as the target mix, so the investor can see whether the manager added or lost value after fees. A fund that lags its blended benchmark by more than its fees deserves questions.
In practice
Real-world examples.
Example
An employee in a workplace plan chooses the moderate fund because she wants growth but dislikes large swings. The fund holds about 60% in shares and the rest in bonds. When shares rally, it sells some automatically to restore the mix.
Example
A retiree selects a conservative target risk fund that holds mostly bonds and cash. He wants stable income and is not comfortable with large falls. After a market drop, his fund falls less than a share fund would.
Example
A small company chooses a range of target risk funds for its employees' savings plan. It offers three options: conservative, moderate and aggressive. The company explains the differences in a short guide and reviews the fund fees every year.
Formula
Calculation
Rebalancing trade = current value of an asset class - (target weight x total portfolio value)
A moderate fund targets 60% shares and 40% bonds and starts with $100,000. Shares rise 20% while bonds are unchanged, so shares are worth 60,000 x 1.20 = $72,000 and bonds are worth $40,000, a total of $112,000. Shares are now 72,000 / 112,000 = 64.3% of the fund. The target value of shares is 0.60 x 112,000 = $67,200, so the manager sells 72,000 - 67,200 = $4,800 of shares and buys $4,800 of bonds, restoring the 60/40 mix.Case study
Seen in the real world.
Oakhaven Advisers is an illustrative, fictional firm that offers a range of target risk funds. Its moderate fund holds 60% shares and 40% bonds, and it rebalances whenever the shares weight drifts more than five percentage points from target.
During a strong year for shares, the fund's equity weight rose to 66%. The manager sold shares worth 6% of the fund's $200,000,000 value, or $12,000,000, and bought bonds.
The following year shares fell sharply. Because the fund had trimmed its shares beforehand, the illustrative loss was a little smaller than it would have been without rebalancing, and the fund bought shares at lower prices to restore the mix. The firm's lesson to clients was that rebalancing is a discipline rather than a forecast.
Watch out
Common mistakes.
- Assuming a target risk fund cannot lose money, when even a conservative fund can fall in value in a bad year.
- Confusing it with a target-date fund, which changes its mix as the retirement date approaches.
- Ignoring the fund's fees, which can reduce long-term returns noticeably, particularly when the fund invests in other funds that charge their own fees.
Questions
People also ask.
What does the risk level in the name mean?
It describes the typical mix of shares and bonds the fund holds, such as conservative, moderate or aggressive.
How is it different from a target-date fund?
A target risk fund keeps a similar risk level over time, while a target-date fund becomes more cautious as the target date nears.
Who manages the mix?
A professional manager, who rebalances the fund periodically according to the fund's stated rules.
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