7. The Solution: Target Date Funds

This is part seven of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here  for part six.

So what exactly are target date funds (TDFs)?  At their core, TDFs are mutual funds.  But unlike mutual funds which might own individual stocks, TDFs are “funds made up of other mutual funds.”  In other words, TDFs do not directly own individual stocks but instead they own index funds, or a bunch of mutual funds in order to provide the investor an appropriate asset mix for retirement (like the asset allocation strategies mentioned in part 3).  In general, TDFs are composed of four primary asset types: 1. US Equity (Stocks and Real Estate) 2. International Equity, 3. Bonds, and 4. Cash Reserves.   The percentage of the fund’s money in each asset depends on the fund’s target retirement date.

For example, Vanguard has a “2020” fund, a “2025” fund, a “2030” fund…. all the way up to a “2055” fund.  If you plan to retire in the year 2055, you should buy the 2055 fund.  The 2055 fund will have more of its assets in stocks than the 2020 fund because more risk is acceptable with retirement that far off.  But the asset allocation of the 2055 fund will not always remain the same.  An important feature of target date funds is that the asset allocation will change (and become more conservative) as you get closer to retirement without you having to buy  a different fund.  So while the 2055 fund may have 90% of its assets in stocks and 10% in bonds today, in the year 2045, your “2055 fund” will have something like 60% stocks and 40% bonds.

Target date funds were created to be a one stop shop for investors.   You start putting money in to one fund in your 20s, and you will continue to put money in that same fund all the way into retirement.  You don’t have to worry about buying different funds to make sure you have the appropriate asset allocation in your portfolio because your target date fund is automatically diversified and rebalanced every year.  Further more, like mutual funds, you don’t have to pay a trade commission every time you put money into it.  So when I first read about TDFs at my HR orientation, it all sounded too good to be true, and I wrote them off because I figured they would have high expense ratios – just like most other mutual funds.  But after months of research on how to be a do-it-yourself investor using index ETFs, I finally concluded it was impossible to overcome the high costs of making online trades – even if it were as few as 3 trades a month.  If I invested $6,000 a year with my ETF strategy, my retirement portfolio would have an effective expense ratio of 6.92%, meaning I would be better off buying mutual funds.  So as much as I had tried to avoid it, it was finally time to reconsider Target Date Funds.

What are my options?  From what I could find there are three major players in the Target Date Fund world: Vanguard, Fidelity and T. Rowe Price.    Here are links to each fund (that is appropriate for my target retirement) along with their expense ratios:

  • Vanguard’s 2050 Fund (VFIFX): 0.19%
  • Fidelity’s 2050 Fund (FFFHX): 0.84%
  • T. Rowe Price’s 2050 Fund (TRRMX): 0.77%

0.19%!  Needless to say I was shocked at how low Vanguard’s expense ratio was, and honestly a little skeptical.  Just for reference, the weighted average expense ratio of all 10 index funds in my preferred asset allocation (described in part 3) was also 0.19%.  By that I mean if you multiplied the expense ratio of each index fund in your portfolio by its allocation percentage you would get your portfolio’s weighted average expense ratio.  For example, the cheapest Vanguard index fund (I’m using vanguard instead of Schwab because overall having a Vanguard account is the cheaper option) for the “Total Stock Market” is VTI with a 0.07% expense ratio.  The cheapest fund for High Yield Corporate Bonds is HYG with a 0.50% expense ratio.  To get the weighted average you would multiply VTI’s 0.07% by VTI’s allocation percentage (25%), add the product of  HYG’s 0.50% ratio and HYG’s allocation percentage (5%), and on and on for each asset.

Though both Vanguard’s Target Date Fund and my ETF portfolio would have the same expense ratio, it is clear that the Vanguard TDF is a much better deal because I wouldn’t have to pay any money on trade commissions (though I still would have to pay the $20 annual account fee).  Even with the obvious solution in front of me, I was curious to know why there was such a difference in expense ratios for funds that were supposed to do the same thing.

Why do similar target date funds have different expense ratios? If you do a little digging you can find out the composition of each fund.  Each fund is slightly different in how much it allocates to US Equity, International Equity, and Bonds, and each fund shows small differences in how that allocation changes over the years.  I’ve include a table below to show the small differences in each funds asset allocation strategy:

What is more intersting, however, is how each fund accomplishes this broad asset allocation.  As mentioned above, each of these target date funds is essentially a fund of funds.  Take the Vanguard Fund.  It is comprised of just 3 funds: The Vanguard Total Stock Market index, the Vanguard Total International Stock index and the Vanguard Total Bond index.  On the other hand, T. Rowe Price’s and Fidelity’s funds are composed of 17 and 20 different funds, respectively.  The extra funds essentially further divide each of the major categories – like US equities – into sub categories.  For example, Fidelity has 10 different funds that make up its “US Equity” allocation and they are shown in the screen shot below:

I suppose that what you are paying for in the extra expense ratio is having your TDF be EXTRA diversified.  The question then is simply this: Is a three fund portfolio properly diversified?  That is probably a question better debated by academics than myself, but I know I feel pretty comfortable with it, especially when considering the drawbacks of the other two funds.

Both the Fidelity and T. Rowe Price funds are made up of actively managed mutual funds – NOT index funds like the Vanguard TDF.  Take Fidelity’s “Small Cap Value Fund” (shown above) for example.  Its investment strategy is to invest “at least 80% of assets in securities of companies with small market capitalizations,”  and to invest in “securities of companies that [the manager] believes are undervalued in the marketplace.”  This is taken straight from Fidelity’s website.  In other words, some guy is picking and choosing what stocks to be in that fund, and as discussed in Part 2, actively managed funds generally do not beat their relevant indexes.  Furthermore, you’ll note that the “Small Cap Value Fund” is part of the US Equity assets, yet it says in the fund’s prospectus that it holds 5% of its assets in international companies!  It’s hard to feel comfortable with a fund whose real asset allocation is almost impossible to compute, much less decided by active management strategies.

The Decision:  In case it is not completely obvious by now, I decided to take my talents, or my money rather, to Vanguard’s target date fund.  Admittedly, I gave up a few things in making the decision.  First, I gave up on the idea that appropriate diversification meant having 10 different funds in your portfolio.  I could have bought one of the other target date funds with a more nuanced diversification – but as I said, I was not comfortable with buying a fund that was composed of actively managed funds.  The second thing I gave up was approximately $2,100 over 30 years.  As it turns out, I can buy the same three funds used in the Vanguard TDF for free with a vanguard account which would result in a weighted average expense ratio of 0.11% percent, compared to the TDF’s expense ratio of 0.19%.  That 0.08% difference adds up to about $2,100 in 30 years.  The way I justify this expense is that I am essentially paying $70 a year to have someone rebalance my portfolio and automatically change my portfolio’s asset allocation as I get older.  To me, having absolutely no stress and no responsibility for my retirement portfolio is worth $70 a year – it may not be for you.

So thats it.  I went from scoffing at target date funds to being a proud owner of Vanguard’s VFIFX fund – and not because I wanted to, but because that was the smartest (and easiest) thing to do.  Hopefully, I’ve convinced you to do the same, but if not, at the very least I hope that you’ll agree that the logic I used to make that decision is sound.

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2 Responses to 7. The Solution: Target Date Funds

  1. Pingback: How long does a mutual fund transaction take? | The Inquiring Investor

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