index funds

Should Target Date Funds Be Standardized?

by Flexo on November 4, 2009

The Security and Exchange Commission (SEC) is setting up a new division to oversee new financial products, and this group is starting with target date funds. These are mutual funds usually taking the form of baskets of other mutual funds, designed to target a certain year of retirement. As the year approaches, the fund automatically changes asset allocation, usually between stocks and bonds, to become less risky.

I’ve pointed out some of my concerns with target date funds here before. Mainly, they could be too conservative and it’s easy to hide fees. Mary Schapiro, the head of the SEC, pointed to the exchanges from stocks to bonds. The cost of the sales and purchases is buried in the daily price of the target date fund, and there is currently no good way for customers to understand how much they are being charged for the re-balancing of the portfolio they could do on their own.

Schapiro also noted that there is no standard across companies. A target date fund designed for those who plan to retire in 2050 with one fund manager may have a different allocation between stocks and bonds than a 2050 target date fund with another fund manager.

Here is a comparison of the asset allocations for the funds designed for those retiring in 2050 from Vanguard, Fidelity, and T. Rowe Price.

	Vanguard	Fidelity	T. Rowe Price
Domestic Stocks	72.0%	69.5%	67.2%
Foreign Stocks	18.0%	20.0%	22.9%
Bonds	10.0%	10.4%	7.2%
Other	0.0%	0.1%	2.7%

The variation seems small but could have an significant effect on returns by retirement in 2050. If target retirement funds were standardized across companies, customers could accurately and easily compare returns between fund managers, understand the level of risk, and have the opportunity to make better investment decisions.

I am not convinced there is a need for this. Any fund’s composition is described in detail in the prospectus and in on a multitude of financial data websites like Yahoo Finance and Google Finance. What isn’t clear are the true fees. We do know that Vanguard’s fee for their 2050 fund is 0.19%, Fidelity’s is 0.82%, and T. Rowe Price’s is 0.79%, but that only tells part of the story. Whenever there is turnover — stocks are sold and other stocks, bonds, or other investments are purchases — fees are generated but wrapped tightly into the daily price of the fund so it is barely noticeable.

Asset re-allocation is the purpose of target date funds. Even if the underlying funds, those in the basket, are low-turnover index funds, the managers may be rearranging the index funds in the basket often. For those disciplined to handle the responsibility of occasional re-balancing themselves, and it’s not that difficult, I suggest avoiding target date funds.

Target date funds have lots of fans because it’s a form of automation, and automation in finances is usually a good thing. There is a danger of automation leading to complacency and a false sense of security. If you choose target date funds, familiarize yourself with the details and evaluate whether the pre-packaged re-allocation system is worth the thousands of dollars or more you could be losing in hidden fees and with a risk profile that doesn’t match your income needs and tolerance.

Would you like to see target date funds standardizes so a “2050 Fund” from one company matches a “2050 Fund” from another company? or should companies be left to determine what strategy is best for their customers?

Photo credit: viZZZual.com
‘Target Date’ Funds Get Senate Scrutiny, Daisy Maxey, Wall Street Journal, October 30, 2009
SEC to look at retirement investing risks, Marketplace, November 3, 2009

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Personal Finance Advice: One Size Does Not Fit All

by Flexo on May 25, 2009

It is human nature to search for Truths that describe the world we live in. This is one reason why personal finance gurus are so popular amongst a group of individuals that listens. Many of the more popular authors, seminar leaders, and cult favorites stick by their mantras, Grand Unifying Theories, such as “credit cards are evil,” “invest in stock index funds for the long term,” and “always buy a used car.”

Any individual who has been able to build a following, cult or otherwise, within the subject of personal finance would do well not to let others peek inside the leader’s own. The advice doles out to the public is usually for a specific intended audience, and it is rare for a guru to fit within the audience he or she is addressing.

In her book, Women and Money, Suze Orman explains that everyone should be invested 100% in stock index funds until close to retirement. This is solid, definitive advice for Suze’s audience, and in this case, men as well. There are some instances where this statement may cause trouble, such as the recent stock market collapse. The book was published in February 2007, as the stock market was reaching a recent peak.

Yet, the average person entering retirement will still have several decades to live, several decades in which the nest egg must last even when being drawn upon. The best way to do this is with a stock index fund. But if we look at Suze Orman’s own portfolio, she doesn’t follow her own advice. As of last year, Orman had $1 million invested in the stock market, a lot of money but only 4% of her own portfolio. The rest was mostly invested in municipal bonds which are very safe but earn less over time. In an interview, she stated she only invests in the stock market what she can afford to lose.

The rules, defined and proliferated by Suze Orman do not apply to her. And they shouldn’t. Why would someone with assets of $25 million follow the same advice as Suze’s audience, in which members might have a net worth anywhere from several hundred thousand dollars below zero, in debt, to several hundred thousand dollars above zero?

The mathematics don’t magically change when you are rich, but the only chance for average individuals to survive through retirement is to take relatively risky bets on the stock market. While the stock market has failed to disappoint in the long term if you look at the numbers, real performance doesn’t always match the statistics thanks to timing. Wealthy individuals, like Suze, can afford to accept less risk. A bond return of 4% on $24 million invested results in an income of $960,000 a year — and that doesn’t include speaking engagements, royalties and television deals. Suze, who is quite comfortable at this stage in her life and career, should not be required to live by the same philosophies she preaches for her callers.

Should you stop following her advice? Suze Orman has helped many people come to terms with their financial condition. But unless you’ve spoken to her about your specific situation, take her mass-market advice with a grain of salt. Yes, her nuggets of wisdom are in many cases helpful, but not everyone falls neatly into the same category.

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Schwab Brokerage Lowers Expense Ratios, Beats Vanguard

by Flexo on May 6, 2009

Here is some good news for investors. Schwab, competing for investment business with other low-cost mutual fund operations like Vanguard, Fidelity, and TIAA-Cref, has lowered the expenses on a number of their mutual funds.

The Schwab S&P 500 Index Fund (SWPIX), which competes directly with the Vanguard S&P 500 Index Funds (VFINX), now sports a net expense ratio of 0.09%, compared with Vanguard’s 0.16% (or 0.15% or 0.18%, depending on who you ask). Additionally, the minimum investment at Schwab is only $100. You will need $3,000 to open an account at Vanguard. Schwab’s Total Stock Market Index Fund (SWTSX) has also been reduced to 0.09%, which is lower than Vanguard’s expense ratio for the equivalent VTSMX of 0.16%.

Theoretically, the performance of an index fund “managed” by one company before fees should be identical to the returns provided by an equivalent fund “managed” elsewhere. With index funds, the fees matter because everything else is theoretically equal; lower expenses could save you many thousands of dollars over long stretches of time. With this news, I may consider at least investing new money with Schwab, and I will possibly consider moving some funds from Vanguard to Schwab.

I should point out that if you qualify for Vanguard’s Admiral Shares, your expense ratios will be lower than Schwab’s new rates. You need to have $100,000 in one mutual fund (or $50,000 in one fund and a ten-year history with that fund) to qualify.

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E*TRADE Eliminating Index Funds

by Flexo on February 27, 2009

E*TRADE has decided to discontinue its collection of index mutual funds. If you hold shares of ETSPX (S&P 500 index fund), ETRUX (Russell 2000 index fund), ETTIX (technology sector index fund), or ETINX (international index fund), E*TRADE or your broker will automatically sell your shares by March 27, 2009.

Even though index funds are likely the best way for most people to invest in the stock market thanks to low fees and returns that match the index, brokerages don’t have much motivation to offer them. Thanks to the low fees, fund managers don’t generate that much income. Without that income, the managers can’t advertise as prominently. E*TRADE’s S&P 500 index fund is quite competitive, with a expense ratio of 0.09%, lower than Vanguard’s 0.15% for VFINX. But VFINX is much more popular.

E*TRADE will likely try to convert index fund customers to managed fund customers. That’s probably the only way for the company to make money. But keeping the customer in mind, I would recommend using the liquidated funds to buy the equivalent low-cost index fund from Vanguard or Fidelity.

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Is “Buy and Hold” Still a Good Investing Strategy?

by Flexo on February 23, 2009

From the time I started investing for the long term, almost all the advice I’ve read has pointed towards buying stocks (usually in the form of index mutual funds) and holding them for decades, rather than following trends in the news and trying to buy and sell stocks frequently. The reasons for this strategy were always similar to these:

Stocks are risky and volatile, but provide the best opportunity for growth over the long term with annual average returns of 7% to 12%, depending on whom you ask, higher than any other type of investment.
Trading costs money thanks to fees, and these fees eat into your returns. They exist to help brokers get rich, so brokers encourage you to trade.
Index mutual funds allow you to invest in stocks for a low cost. Other mutual funds try and mostly fail to beat the indexes, and charge higher fees regardless of their success.
Index funds also allow you to broadly diversify, reducing your exposure to the success of any company you invest in.

Have these fundamentals changed? A recent article in MSN Money claims that the advice is a lie. The reason for this is that the “level of risk in the stock market changed violently” in 2007. If this were true, investors who believed they built a moderately risky portfolio including stocks and bonds or cash prior to 2007 would suddenly have a riskier portfolio. I was under the impression that stocks were always risky, which is why they provide the opportunity for the largest long-term growth.

Looking back at 2007, it’s quite easy to pinpoint the exact moment you should have sold stocks. It’s also easy to look at what was happening in the market, point at something, and declare it was a “sign” that it was time to get out of the market.

I am still sticking with “buy and hold” as a long-term growth strategy. Yes, if I were to sell my investments now, I would lose a large amount of invested money. But I’m not selling now, I’m still buying.

Have the fundamentals changed? Are stocks riskier now or is this volatility just a side effect of the risk that has been there all along? Is the “buy and hold” strategy just a fad that is no longer relevant for today’s stock market?

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ETFs or Index Funds: Which are Right for You?

by Flexo on February 6, 2009

About the author: This guest article is presented by ABCs of Investing, a new website for novice investors which offers two short and simple investing posts each week. Feel free to subscribe the the RSS feed.

With last year’s market meltdown affecting both managed mutual funds as well as their low-cost counterparts index funds and exchange-traded funds (ETFs), many investors are asking why they are paying extra money for managers who manage to lose just as much money as the passive instruments. They might also be thinking ahead to the good times when those same high fees will help reduce the managed mutual fund returns.

If you decide to jump into passive investing you may ask yourself a question common among investors, “Should I invest in index funds, exchange-traded funds, or both?”

There is no quick answer to this question. I think low cost index funds are the best choice for most investors and I will illustrate why in the rest of the post. First, let’s take a quick look at some important differences between index funds and ETFs.

What is an index fund?

An index fund is a mutual fund that invests in the same stocks that are contained in a stock market index, in the same proportion as the stock index.

Imagine a stock index that contains two stocks, IBM and Microsoft (MSFT). Let’s call it the ABC index. Let’s say that the ABC index consists of 60% IBM and 40% Microsoft. If an index fund is based on the ABC index then it, too, will invest in IBM and Microsoft, in the same proportion and allocation as index: 60% in IBM and 40% in Microsoft.

These percentages will change as the values of IBM and Microsoft change. If the price of the IBM stock increases and the price of Microsoft decreases then the index will change so that maybe 65% will be IBM and only 35% will be Microsoft.

What is an exchange-traded fund?

An exchange traded fund or ETF is an investment that contains the same stocks of a stock market index, in the same proportion as the stock index. If you are thinking this sounds a lot like index funds, you would be correct!

How index funds and ETFs are valued

The price of an ETF or index fund is determined by the value of the stocks contained in the underlying index. For example, the Vanguard Total Stock Market exchange traded fund (VTI) is an ETF that covers most of the stocks available in the US. As the price of the underlying stocks change value, the ETF price will also change because investors will bid the ETF shares higher or lower.

Differences between ETFs and index funds

One of the key differences between index funds and ETFs is that index funds are priced once a day. It doesn’t matter what time you put your order in, the price you get will be set at the end of the trading day (4:00pm EST). ETFs on the other hand are priced throughout the day in a similar fashion to stocks.

A second key difference is in order to purchase ETFs you have to pay a trading commission like you would with a single company stock.

Factors to consider when deciding between ETFs and index funds

Management expense ratio (MER). This is the basic cost of running an index fund or ETF. You won’t see the management fee deducted in any of your statements but you can find out what it is from the investment company website or Morningstar.com. Generally speaking, ETFs tend to be cheaper than a similar index funds however this can vary. It is very important to make sure you know the MER of any type of index fund or ETF you are considering.

Let’s look at an example. VTI contains all the publicly traded American stocks. The expense ratio is 0.07% which means that for every $10,000 of VTI you own Vanguard will charge you $7. Keep in mind this fee gets deducted directly from the fund. You don’t get charged separately.

The index fund counterpart to VTI is called the Vanguard Total Stock Market Index Fund (VTSMX). This fund comes with two different expense ratios.

0.15% if you have between $3,000 and $100,000. These are the Investor Shares.
0.07% if you have more than $100,000. These are the Admiral Shares.

From these numbers you can see that if you have less than $100,000 then the ETF version would be lower cost, but with over $100,000 the fees are a wash. But the expense ratio is not the only cost!

Trading costs. These are the costs associated with buying more units or shares of an index fund or ETF. Typically you don’t have to pay trading costs with mutual funds (index funds are a type of mutual fund), especially if it is a regularly scheduled purchase.

ETFs on the other hand need to be purchased through a brokerage so you will have to pay trading fees every time you make a purchase. There are some cheap options. For example, Zecco charges $4.50 per trade (or no fee if you have over $25,000 in your account) and TradeKing charges $4.95 per trade. These fees can add up, especially if you want to make more than one purchase per month.

If you consider both the expense ratio and the trading costs then the best choice really depends on the specific funds you are looking at as well as your trading costs. Usually you need a fairly large portfolio to be able to take advantage of the (usually) lower costs of ETFs. As a simple rule of thumb, if you have less than $100,000 in total you are probably better off with index funds. The Admiral series from Vanguard has great deals for index funds but you need a minimum of $100,000 per fund unless you want only one fund in your portfolio then you need some serious dough to be able to take advantage of them.

Automation of trades. One of the great advantages to index funds (and mutual funds in general) is that you can automate your purchases. If you want to contribute a certain dollar amount each month in a few different funds, automating that process allows you to “set it and forget it.” Once you set up the automated monthly purchases, money will be pulled from your bank account and the purchases will be made without any human intervention. This is the single biggest reason why I think that most investors should invest in index funds rather than ETFs if they make regular purchases.

Automation is a big issue for two reasons:

Laziness is the enemy. If I have to log in and do some trades every month, once the novelty wears off then I will be sure to forget.
Market timing. As a passive investor I know I’m wasting my time by trying to time the market. Regardless, every single time I’ve ever had to place an order for an ETF, I always try to time the market. I will sit there and watch the price movements for a while and see if I can get a better price. Once the order is finally placed then I’ll check back later to see if I should have waited a while before buying. This behavior is a complete waste of time but inexplicably, I do it every time. Buying index funds on a monthly purchase plan will save me a lot of time and stress.

Conclusion

Like many things in life, there is no clear answer to the question of whether index funds or ETFs are the better investment vehicle for you. Expense ratios, size of portfolio and frequency of trading are all important variables to consider, but I think for most investors, index funds are superior.

If you enjoyed this article, please visit ABCs of Investing for more articles for the investing novice. We would appreciate your comments and reactions, so if you would like to contribute to the discussion, add your comment below.

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The Benefits of Target Retirement Funds

by Guest Author on June 19, 2008

About the author: The following is a guest article written by Kevin from No Debt Plan. He writes to help readers eliminate debt, learn how to budget and save, and move themselves towards financial freedom.

The first investment we made in one of our Roth IRAs was in a Vanguard Target Retirement fund. Generally target date retirement funds make good investments; if you are just starting to save for retirement it’s a great investment. Flexo recently shared his reservations about these investments, but today I’ll give you four reasons why we like them.

It’s an easy start.
Low investment needed to start.
You get instant diversification.
The fund automatically rebalances based on your age.

Let’s look at these individually.

An easy start. You need only one account (Roth IRA, Traditional IRA, taxable investment account, etc.). You invest in one fund. That’s pretty easy to get going and removes a bunch of hurdles.

Low investment needed to start. With any target retirement fund, the only start up cost you have is your minimum investment and then associated expense fees. We opened our Roth IRA with Vanguard because they are known for having low expense fees, and the minimum investments are only $3,000. Once you invest your first $3,000, you can add as little as $100 to your account after that. The kicker is you only need the one fund to get started, which leads us to…

Instant Diversification. The reason you only need one fund starting out, is a target retirement fund gives you a great deal of diversification right off the bat. Let’s take a look at Vanguard’s Target Retirement 2050 Fund (VFIFX) that we are currently invested in:

71.61% Vanguard Total Stock Market
10.09% Vanguard Total Bond Market
9.97% Vanguard European Stock Index
4.39% Vanguard Pacific Stock Index
3.62% Vanguard Emerging Markets Index
0.16% Vanguard Total Stock Market ETF

With one fund, you’re invested in 5 other major investments. Starting out you probably want a large amount of US and International stock exposure. Even if you just wanted these two things you would need two funds to get that diversification. Two funds means two minimum investments. Add additional funds and you add additional minimum investments. Not so with the target retirement fund. One minimum investment and you suddenly have instant diversification.

Automatic Rebalancing. Rebalancing is the act of sitting down once per year and adjusting your portfolio toward your target asset allocation. Let’s say you hold two funds because you want a 50% US stock exposure and 50% International stock exposure. During the last year, it is unlikely the funds have gained and lost exactly the same. So you end the year and US stocks have been up more than International stocks. Your current portfolio weight is 53% US and 47% International.

Doesn’t sound like a big deal, right? Just 3%. Well, over time that gap can get larger and larger until one day you find yourself with a 75/25 allocation — way out of whack.

With a target retirement fund, you don’t have to worry about rebalancing. If 100% of your portfolio was in the fund (not a recommendation, just an example), the fund will rebalance for you every year. As time marches on you will get closer and closer to the target date for the fund. As you get closer, the fund adjusts the portfolio for you to be more conservative.

Let’s compare two of Vanguard’s funds, the Target Retirement 2010 (VTENX) and Target Retirement 2050, to make the point clear. We expect the 2010 fund to have fewer stocks and more bonds/income generating investments than the 2050 portfolio listed above. The 2010 investments include:

44.08% Vanguard Total Stock Market Index
40.28% Vanguard Total Bond Market Index
6.18% Vanguard European Stock Index
4.43% Vanguard Inflation-Protected Securities
2.69% Vanguard Pacific Stock Index
2.27% Vanguard Emerging Markets Stock Index
0.05% Vanguard Total Stock Market ETF

The 2010 fund is 55.27% stocks and 44.73% non-stock investments. The 2050 fund is 89.91% stocks and 10.09% bonds. An obviously difference. Over time, the 2050 fund will start to look more and more like the 2010 fund.

What are you waiting for? For all of you new investors out there, I honestly think a Vanguard Target Retirement Fund is one of the best initial investments you could make.

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Target Retirement Funds (Also Known As Lifecycle Funds)

by Flexo on June 18, 2008