A
target risk fund
offers investors another way to focus on a specific goal with an individual fund. In these
funds of funds,
professional managers use the money you invest to build a diversified portfolio of funds that aim to generate as much return as possible at the specific level of risk you’re comfortable with. Unlike a
target date fund,
the fund’s investment objective — using asset allocation and diversification to stabilize risk levels and maximize return — remains consistent over time, although the actual composition of the fund may change in response to market conditions. Target risk funds explain their risk profile in their
prospectus.
Choosing a target risk fund
If you’re considering a target risk fund, it’s important to keep in mind your time frame and the goal you’re trying to achieve. But your main criteria will be your
risk tolerance — the amount of investment risk you’re comfortable taking.
To determine your risk tolerance, you can work with an investment professional to complete a risk assessment profile, which will establish where you stand along the risk spectrum of conservative, moderate, and aggressive investing and help determine a mix of investments that’s appropriate for your comfort level. Once you pinpoint your risk tolerance, you can look for a target risk fund that’s suitable for your goals and timeframe.
Of course, your risk tolerance may change over time — either because of changes in your life or simply because your time frame is getting shorter. If you’ve invested in a target risk fund and your risk tolerance changes, you’ll want to consider switching to a fund that matches your current attitude and objectives
.
Rebalancing
In order to keep the level of risk consistent, target risk funds need to reallocate their portfolios periodically. For instance, when the performance of an underlying asset is particularly strong, the asset will have more weight in the overall fund and exert more influence on the return. This can throw off the carefully calibrated balance that’s necessary to maintain the specific risk target, requiring the fund managers to systematically sell off portions of the overweighted asset to bring the risk level back into balance.
In a tax-deferred or tax-free account, this rebalancing doesn’t have tax consequences. In a taxable account, you may owe either short-term or long-term
capital gains.
Efficient frontier
Choosing the underlying funds that allow a target risk fund to meet its objective can be a complex process. Fund managers use computer modeling to help select underlying funds and determine what percentages they should allocate to each fund. The computers plot the expected return on thousands of combinations of funds against their specific risk levels. The resulting graph helps determine the allocations that will yield the highest return at the necessary risk level. The line on the graph showing the relationship between risk and projected return is known as the efficient frontier.
If you select a fixed track in a state-sponsored
529 savings plan,
you’re essentially investing in a target risk fund, although it probably won’t be referred to in those terms.
