Mutual 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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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.

If you enjoyed this article, please visit No Debt Plan for more thoughts about saving money and avoiding debt at all costs. 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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Target Retirement Funds (Also Known As Lifecycle Funds)

by Flexo on June 18, 2008

Target retirement funds are increasing in popularity. The funds, and they may be called “lifecycle funds” or “target date funds” or “age-based funds” or a variety of other terms are mutual funds comprising other mutual funds. The allocation percentages of the constituent mutual funds change as time progresses, theoretically becoming more conservative as you approach your target.

For example, the Vanguard Target Retirement 2050 Fund (VFIFX) is a mutual fund of funds designed for people who expect to retire in the year 2050. You would expect an investment — one that is designed to mirror your investing strategy based on your time horizon — to be quite aggressive in order to make the most of the decades between now and the time you need to access its value.

This reveals the first problem I have with target retirement funds: they are often too conservative. VFIFX contains five other Vanguard mutual funds: Vanguard Total Stock Market Index Fund, Vanguard Total Bond Market Index Fund, Vanguard European Stock Market Index Fund, Vanguard Pacific Stock Index Fund, and Vanguard Emerging Markets Stock Index Fund. As of today, 72% of the fund is invested in the Total Stock Market, 10% is invested in the Total Bond Market, and the remaining 18% is split between the others in amounts hardly meaningful.

I don’t see this as aggressive enough for someone who has such a long time horizon. I would suggest eliminating the bond component entirely and distributing the rest towards the international funds.

My second issue with target retirement funds is how it could lull an investor into a false sense of safety and security. While creating a hands-off approach to investing, it encourages buying and holding which is great for long-term success, but it opens the door to complacency. Your reallocations are on auto-pilot, so if you decide to change your time horizon, you may find yourself under or over-exposed to risk. Also, Vanguard, or which ever management company you choose for your target retirement fund, may decide to change strategies in the future, to the point where their guidelines no longer match your expectations.

Target retirement funds to encompass your entire portfolio. If you’ve chosen the Vanguard Target Retirement 2050 Fund for your entire 401(k) election, but you have a Roth IRA where this fund is not available, then you’re modifying your asset allocation away from that prescribed by Vanguard. If you are comfortable with Vanguard’s exposure to equities in their fund but you decide to invest in VTSMX separately in your Roth IRA, you’ve disturbed your overall asset allocation and opened yourself up to risk you may not have intended for your retirement funds.

Fund managing companies can’t seem to agree on the most appropriate asset allocation for a certain target. I mentioned Vanguard’s current allocation rule for its “2050″ fund. Fidelity has a different strategy for those retiring the same year. The Fidelity Freedom 2050 Fund (FFFHX) invests in 68.5% domestic stock funds, 20.9% international stock funds, and 10.5% bond funds. Overall, this is similar to to Vanguard fund of funds, but the specific composition of the international portion provides a strong enough contrast that could have profound effects over 40 years of investment.

The fees for target retirement funds are usually a combination of the fees of the underlying investments. Rarely, a target retirement fund will add a management fee in addition to the feeds already charged by the funds held. Pay attention to these fees, because they will eat into the value of your investment. With a distant target like 2050, the fees eat into your returns even more.

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The Only 7 Investments You Need

by Flexo on May 16, 2008

Money Magazine is recommending that those wishing to build their net worth over a long period of time simplify matters by putting all their eggs into seven baskets in the form of mutual funds.

1. Fidelity Spartan 500 Index (FSMKX). This fund’s total expense ratio is a minuscule 0.10%. It tracks the S&P 500 index.

2. Vanguard Total International Stock Index (VGTSX). “Nearly 60% of the world’s stock market value resides in companies outside our borders,” so you’ll want a piece of that action.

3. T. Rowe Price New Horizons (PRNHX). New Horizons is a small company stock fund. There are periods of time in which small company stocks have outperformed the market at large. This isn’t an index fund, though, so expect to pay an expense ratio of 0.79%, still low for managed funds.

4. Vanguard Value Index (VIVAX) . If you pay attention to value funds, your investments will return dividends. Literally. This fund currently offers a dividend yield of 2.94%.

Wall Street subway station 5. Vanguard Total Bond Market Index (VBMFX). Got bonds? I don’t. But if your asset allocation calls for bonds, this fund beat the industry average by 14% over the past 10 years and its expense ratio is 0.20%.

6. Vanguard Inflation-Protected Securities Fund (VIPSX). First of all, official government inflation statistics underestimate the real increase in prices we see every year, partly because those who calculate the statistics assume Americans “trade down” to lower quality products when prices get high. Thus, inflation-protected securities are likely misguided. Money Magazine has nevertheless included them among the other suggestions.

7. Fidelity Cash Reserves (FDRXX). Cash reserves are good for when you spot a buying opportunity in the market and need flexibility and liquidity to jump. A money market fund like this is decent for at least part of your emergency fund. Personally, since I have some of my retirement accounts at Vanguard, I chose Money Magazine’s alternate, VMMXX. This Vanguard fund features an expense ratio of 0.24% compared to Fidelity’s 0.40%.

Probably more important than the specific funds is the overall asset allocation strategy. Investors spend a lot of time talking about investments, analyzing and choosing the best funds that will help us reach our goals, but asset allocation is just as important. If an investor ignores his allocations, her investments might not provide the results.

Photo credit: epicharmus
The Only 7 Investments You Need [Money Magazine]

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Thrasher Funds’ GendeX Mutual Fund: You Know, For Kids

by Flexo on March 27, 2008