Suze Orman: Avoid Target-Date Funds Because They Will Slide as Interest Rates Rise

publication date: Aug 22, 2011

With stock prices falling and stock market volatility up, CNBC has expanded their evening coverage of the carnage. They had their usual assortment of experts, pseudo-experts and journalists on air recently to address questions and concerns. And, they made the mistake of having Suze Orman join them (see my previous article on her background). Having observed her for many years, I've lost track of how many clueless and erroneous things I've heard her say.

But, just as some folks can't turn away from viewing the results of an accident on the highway, I resisted my instinct to immediately change the channel when she came on the screen. Within two minutes, she had efficiently presented me with yet another golden opportunity to debunk some silly investing advice she provided a viewer.

When to Invest in Bonds

In response to a viewer question regarding how to invest in his company's 401(k) plan, she asked him if like most such company retirement plans, were target-date funds offered. The viewer said yes which prompted Ms. Orman to go on a rant against target-date funds. She doesn't like them because they don't try to jump into and out of bonds based upon expected changes in interest rates. (Bond prices fall when market interest rates rise).

An example of a target-date fund is Vanguard's Target Retirement 2040 Fund, which is designed for investors expecting to retire around the year 2040. The fund currently has about 90 percent invested in stocks and 10 percent in bonds. In the year 2016 (about 25 years from the expected retirement date), the fund will begin to gradually increase its bond holdings while slowly reducing its stock holdings. That's what investors are generally advised to do approaching retirement and a target date fund ensures that it happens (at least for the money that an investor has in such a fund).

Suze Orman: Wrong Again!

In the world according to Suze Orman, investing in bonds is a simple matter of figuring out which way interest rates are going to go and then making your bond investments accordingly! Of course, this is absurd and near impossible to do, even for the vast, vast majority of professional money managers.


If you can consistently predict which way various interest rates are headed, you could make a fortune correctly betting on various financial products the performance of which depend upon which way interest rates are going.

Listen to Vanguard, Not Suze Orman

Vanguard recently published a useful report on this topic entitled, "Rising Rates: A Case for Active Bond Investing?" Here are the key insights from that report:

"Although the success of active management in fixed income has not been stellar-Vanguard research has found, for example, that over the 15 years ended December 31, 2010, more than 85% of actively managed bond funds failed to beat their benchmarks-still there are distinct periods in which investors may prefer active management. For instance, during a rising interest rate environment, it is often supposed that active fixed income managers will outperform their benchmark, given that active managers can shorten a portfolio's duration, thus mitigating the risk of rising interest rates.

This paper tests this assumption by reviewing the historical track record of active bond managers in Morningstar's mutual fund database during periods of rising interest rates since 1981.

...We found that in a majority of rising-rate periods, active managers, on average, failed to outperform a relevant benchmark. The implication of this finding is that investors should not assume that an active manager will automatically transform an opportunity to outperform into actual outperformance.

...Given active managers' ability to position their portfolios according to market conditions, why has outperformance during rising-rate periods been so fleeting? There are two likely reasons: first, the effect on the market of the zero-sum game; and, second, the difficulty of predicting (and therefore capitalizing on) interest rate movements.

The concept of a zero-sum game in investing starts with the understanding that at any given point in time, the holdings of all investors in a particular market, such as the U.S. bond market, aggregate to form that market. Because all investors' holdings are represented, if one investor's dollars outperform the aggregate market over a particular time period, another investor's dollars must underperform, such that the dollar-weighted performance of all investors sums to equal the performance of the market.

In reality, investors are exposed to costs such as commissions, management fees, bid-ask spreads, administrative costs, market impact, and, where applicable, taxes-all of which combine to reduce realized returns over time. As a result, after costs are considered, investors' dollar-weighted underperformance exceeds investors' dollarweighted outperformance. By extension, a majority of investor dollars also therefore underperforms the market index...the average dollar invested in actively managed bond funds was charged 54 basis points (0.54%) for government funds and 56 basis points (0.56%) for corporate funds, amounts that constitute significant hurdles for those funds to overcome to outperform a benchmark.

As stated, we also want to emphasize how hard it is to correctly predict interest rate movements (and, for corporate bonds, credit spreads and sector performance) consistently over time...As observed in previous Vanguard research by Davis et al. (2010), the forward yield curve of the Treasury market reflects the aggregate perspective of investment managers on future interest rates. Note that forward rates do not represent any individual's or organization's views about future interest rates. Instead, the forward curve represents the aggregate expectations of all Treasury bond-market participants regarding future interest rates...

Of course, history suggests that interest rates will likely evolve differently from today's expectations. Indeed, as Davis et al. (2010) also showed, the Treasury forward yield curve has been a poor predictor of actual future rates...A timely example of this evolution of actual versus expected rates has transpired since interest rates bottomed in 2008. Since that point, market participants have been forecasting higher future interest rates. Yet, despite the clamor for higher rates, yields have remained low, with little upward pressure.

Finally, in addition to interest rates' unpredictability, it's important to consider that even if a manager makes a correct call on the direction of rates, the timing and magnitude of any change are crucial...In an environment characterized by a steep yield curve, this negative carry can mean a significant return forfeiture if yields do not rise as anticipated.

Even then, a manager who correctly predicts a rise in interest rates could likely suffer a performance penalty if rates rise less than forecast or if the timing of the change is either too early or too late."

For more specific investing suggestions and ideas on this topic, please see my previous article, "Dealing With Worries About Rising Interest Rates".


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Copyright Eric Tyson, 2008 - 2023 all rights reserved.

Eric Tyson is the only best-selling personal finance author who has an extensive background as an hourly-based financial advisor and who does not accept speaking fees, endorsement deals or fees of any type from companies in the financial services industry or product or service providers recommended in his articles, books and his publications.