Beware of the Black Box

Do you know what’s inside you’re Target Date Fund?

If you read my post from July 2013, and let’s face it most of you didn’t (you can find it here), then you already know my feelings about Black Boxes.  I hate them!  For those of you that don’t know what I mean, in the financial world, a black box is created by taking a relatively simple instrument or group of instruments, giving it either a cool techy or real simple name and putting it in a “black box” so no one knows what’s really inside.  Such is the case with the Target Date Fund.

If you are invested in your company 401(k) or an IRA there’s a good chance you’re holding a target date fund.  The concept is pretty simple.  You pick a fund with a date in the name that’s pretty close to the date you plan to retire and close your eyes.  In theory the fund manager will manage the risk in the fund by moving from stocks to bonds periodically as the fund’s target date (and your retirement date) gets closer.  Sounds like such a great idea that these have become the primary and default investment vehicle for many 401(k) plans.

So what’s’ the problem?  Simple.  Like any investment vehicle that has a cloak of secrecy surrounding how it works, there are no rules, regulations, or guidelines that dictate how the risk is managed in these funds.  You assume that your risk is managed because that is what you’re being lead to believe.  Forget the fact that bonds aren’t the safe haven that we think they are (I’ll get to that in a future post).

There have been many studies lately that show these funds carrying much more risk than they probably should, mainly because the manager needs to show better performance than the competition.  This leads to holding more equities in the portfolio longer than they should, given the mandate of the fund.  Unfortunately, this revelation may come too late for many if we have another downturn in the market like 2008.

Understanding what you’re invested in is the first step to being able to manage the risk in your portfolio.  We have a long history that tells us that black box investing rarely ends well.

If you don’t understand your investments than it may be time to take another look.

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David J. Seibel is founder and Managing Partner of AGS Aurora Financial Services LLC (www.agsaurora.com), an independent financial advisory firm in Matawan, New Jersey. You may contact him by email at david.seibel@agsaurora.com.

Investment Advisory Services offered through Global Financial Private Capital, LLC a SEC Registered Investment Advisor