Target-date funds, a popular feature in many 401(k) plans, can be a decent investment option–provided that you know what to expect.

Target-date mutual funds promise to take the guesswork out of investing. With these popular offerings, investors don’t have to worry about adjusting their asset allocation strategy over their lifetime. As the fund approaches its target date, the manager automatically dials down the risk.

The simplicity of these vehicles led many investors to forego the traditional portfolio mix of individual stocks and bonds. Instead, many simply parked their assets in a single target-date fund and left the legwork to fund managers. The US Dept of Labor went so far as to recommend target-date funds as the default investment option in all 401(k) plans.

But as the financial crisis and Great Recession roiled markets, many funds that were nearing their target date sank like stones. Some even gave up as much as 40 percent of their value. These losses confounded investors who rightfully expected these investments to become less risky over time

There were two reasons for this reversal of fortune. First, in 2008 investors fled en masse to safe-haven investments, making Treasury notes one of the few asset classes to eke out a gain.

Second, asset managers follow different approaches to managing target-date funds. Some managers believed these funds should reach the most conservative point of their arc at the target date, and ran their charges as if they were targeted-risk funds. Other managers adhered to a “life-cycle” approach to investing. These funds grew more conservative as their investors aged and wouldn’t reach their most conservative allocations until about 15 years after the target date.

If investors didn’t understand the nuances of these investment strategies, they experienced some nasty surprises in 2008 and 2009.

The Securities and Exchange Commission has proposed rules that would make it easier for investors to understand target-date funds. Fund managers would be required to provide projections for their funds’ asset allocations at various junctures. The rules also call for the prospectus to contain clearer explanations of how a fund will be managed in respect to its target date. All marketing materials would be required list the security classes in which the target-date fund might invest.

Even with these clarifications, many investors will surely be left wondering which target-date fund is suitable for their long-term financial goals.

Picking Winners

The first step in selecting a target-date fund is to understand how the offering’s asset allocation strategy will evolve–information contained in the prospectus. Failing to understand how the fund’s risk exposure will change over time could jeopardize your long-term investment goals.

Decades of research have demonstrated that high expenses are a significant drag on a fund’s performance. As a rule of thumb, only consider funds with expense ratios lower than 0.70 percent.

Investors must also examine the target-date fund’s holdings. Unlike traditional funds that invest in individual stocks and bonds, many target-date offerings are structured as funds of funds, or mutual funds that invest in other mutual funds

Before sinking your hard-earned money into a target-date fund, you should perform due diligence on the funds in its portfolio to ensure that the underlying holdings are solid investments.

Recently, more target-dated funds have added commodity, real estate and alternative strategy funds to their portfolios. Although these investments can improve a fund of fund’s diversification, you should make sure that the allocation to these riskier asset classes doesn’t exceed 10 percent.

Also, be mindful of how many funds your target-date fund holds in its portfolio. Too few funds, and your target-date fund won’t be well-diversified; too many funds will result in redundancies and higher expenses. Generally speaking, about 15 underlying funds are enough to provide diversification without too much duplication.

In most cases, it’s better to invest in a target-date fund that builds its portfolio around index funds, which typically sport lower expense ratios, rather than actively managed offerings.

Realistic Expectations

These funds specialize in prudently allocating assets over time, so their performance will never keep pace with the new flavor of the month. Nor do they do they match the stability of the best value funds; target-date funds can suffer difficult months or years. “Realistic Expectations” shows how funds with different target dates have performed and how much risk they entail as measured by standard deviation. Nevertheless, the promise of a fund whose risk profile evolves as you approach retirement remains appealing.