Archives for May 2011

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Is a Single Target Retirement Fund Really OK?

Target retirement funds (aka target date funds) are meant to be a one-fund solution to investing. Many investors, however, are somewhat reluctant to put everything in a single fund. It just doesn’t feel diversified.

I would argue, however, that if you can find a target retirement fund with an asset allocation and “glide path” (projected asset allocation over time) appropriate for your level of risk tolerance, it can be perfectly OK to use that fund for your entire portfolio.

Important note: Do not pick a target date fund based on the date in the name. Pick based on the fund’s asset allocation. You may find that the fund that best fits your own tolerance for risk is the one typically intended for investors retiring 10 or 15 years earlier or later than you.

Vanguard’s target retirement funds* are portfolios comprised of Vanguard Total Stock Market Index Fund, Vanguard Total International Stock Index Fund, Vanguard Total Bond Market Index Fund, a small money market holding, and (in the most conservative of the target funds) Vanguard Inflation-Protected Securities Fund.

According to Vanguard’s site, as of 3/31/2011:

  • Vanguard Total Stock Market includes 3,380 stocks,
  • Vanguard Total International includes 6,517 stocks, and
  • Vanguard Total Bond Market includes 4,907 different bonds.

In other words, with just one target retirement fund, you can achieve an extreme level of diversification–almost 10,000 stocks (spread across several different countries), plus a diversified portfolio of bonds. In my opinion, that’s as diversified as anyone needs to be.

Target Retirement Fund Drawbacks

Of course, target date funds have their drawbacks too.

First, if your portfolio is large enough, you could achieve slightly lower expenses by using individual funds–Vanguard Admiral shares or ETFs, or Fidelity Spartan funds, for example.

Second, for investors in taxable accounts, target date funds could be less tax-efficient than a portfolio created of separate funds. For example, an investor in a high tax bracket could benefit from using tax-exempt municipal bonds rather than the taxable bonds included in a target retirement fund.

Finally, there’s no guarantee that the fund company will stick to the planned glide path. That is, the current plan may be for the fund to have a certain allocation 15 years from now, but the fund company can change that plan at any time. The result: An investor who is a little too oblivious could end up with a different allocation than he/she had anticipated.

Simple Yet Sophisticated

Despite the above imperfections, a single Vanguard target retirement fund (checked periodically to make sure the allocation and projected glide path are still in line with your goals) is actually a quite sophisticated portfolio for an investor in a tax-sheltered retirement account. They offer extreme diversification and automatic rebalancing, all for an expense ratio of less than 0.2%.

Not bad, if you ask me.

*Except in an employer plan, I wouldn’t use any target retirement funds other than Vanguard’s. According to Morningstar, Vanguard’s target funds cost just 0.18% per year. The next-cheapest company (Wells Fargo) charges three and a half times as much (0.63%), and it only gets worse from there.

Update: iShares also offers a line of target date ETFs that was apparently excluded from the Morningstar study. With expense ratios of 0.29%, they’re decidedly lower-cost than most of the competition, though still pricier than Vanguard.

Mutual Funds and Management Risk

The Fairholme fund is an actively managed mutual fund run by a fellow named Bruce Berkowitz. Since the fund’s inception in 1999, Berkowitz has had an impressive run. According to Morningstar, the Fairholme fund is in the top 1% of funds in its category (large-cap value funds) for both 5-year and 10-year annualized returns. That’s quite an achievement!

However, as esteemed investment author Taylor Larimore recently pointed out, the fund’s performance has been rather lacking over the last year. In fact, it’s been pretty bad. For the twelve months ending 4/29/2011, Fairholme is in the bottom 1% of funds in its category. Yikes.

So what does that mean for investors in that fund? Is Berkowitz’s hot streak over? Or is this just a short-term hiccup in what will turn out to be another decade of superstar performance?

I have no idea.

And that’s the point.

Actively Manged Funds: You Can Never Be Sure.

When you own an actively managed fund, there will be periods during which your fund underperforms its benchmark and its peers–sometimes dramatically. When that happens, you have to decide whether or not you want to continue holding the fund, which means trying to determine whether:

  1. The poor performance is just a fluke and your actively managed fund’s performance will soon pick back up,
  2. The fund manager has “lost his touch.” (For example, he had previously succeeded by exploiting a particular market inefficiency, but that inefficiency has now become public knowledge, rendering it ineffective and leaving your manager scrambling to find a new trick.),
  3. The fund has grown so large that the fund manager can no longer handle it effectively, or
  4. The fund manager was never anything but lucky in the first place, and his luck has now run out.

Years later, with the benefit of hindsight, you may be able to tell which of those scenarios was actually the case. But while it’s actually happening, all you can know with certainty is that your fund is losing money and falling behind its peers.

Yet Another Reason I Like Index Funds

When you invest in index funds, the overwhelming majority of your funds’ performance will be explained by two things:

  1. The performance of the underlying indexes, and
  2. The funds’ costs. (Lower costs = better returns.)

As a result, you don’t have to spend time researching fund managers. You don’t have to spend time trying to determine whether a particular manager is skillful rather than just lucky. And you don’t have to spend time worrying about whether your fund’s manager has “lost his touch.”

Truth be told, I don’t even know the names of the people who run the funds I own. It’s not that I don’t appreciate their work. It’s just that the information isn’t particularly relevant to what I do with my portfolio.

If you’re an index fund investor, management risk–the risk that your fund’s performance will be harmed by the manager’s poor decisions–is one thing you don’t have to worry about.

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