Friday, October 1, 2010

A Single Fund Solution

If you can’t find the time, interest or energy to learn much about investing and to manage your investments, perhaps you would be interested in investing in a single mutual fund that will provide broad diversification, and will be appropriate to invest in for the rest of your life. Types of funds that are intended to meet these goals are known as target-date, target-retirement, or life-cycle funds.

In general, target-date funds gradually lower risk by reducing the allocation to stocks each year. This is consistent with the widely recommended approach of taking more risk when you’re young, and decreasing risk as you get older. As with most other mutual funds, my favorite provider of this type of fund is Vanguard, and they are in the process of making some changes to these funds that make them even more attractive from my perspective. I’ll use Vanguard’s Target Retirement funds to illustrate how target-date funds work, and why they may be an appropriate investment for people who want a low-maintenance, prudent approach to investing.

Vanguard’s target-date funds have names like Target Retirement 2020, Target Retirement 2030, etc. The target-date funds with target dates further in the future have higher stock allocations and lower bond allocations. For example, the Target Retirement 2020 fund currently has about 67% stocks and 33% bonds, while the Target Retirement 2030 fund has about 82% stocks and 18% bonds. Over time, the Target Retirement 2030 fund will gradually reduce its stock allocation and increase its bond allocation; in 10 years the allocation should be similar to the current allocation of the Target Retirement 2020 fund. Vanguard’s Target Retirement 2035 Fund and beyond (2040, 2045, 2050, 2055) all have about 90% stocks and 10% fixed income, which of course is a very high-risk allocation, but may be appropriate for someone with 25 years or more until retirement.

Several years beyond the target-retirement date, a target-retirement fund will reach an allocation that Vanguard considers appropriate for people in retirement. The Vanguard Target Retirement Income Fund is intended for someone who has been retired for 7 years or more, and has about 30% stocks, 65% bonds, and 5% cash. All Vanguard target-retirement funds will eventually reach the allocation of the Target Retirement Income Fund, then remain there. For example, the Target Retirement 2010 Fund currently has a stock allocation of about 50%, but by 2017 it will be down to about 30%.

The basic idea is that you pick the fund with the date closest to the date you plan to retire. However, I wouldn’t necessarily recommend this approach, since what’s really important is that you select a fund that’s appropriate for your risk tolerance. For example, you may plan to retire around 2030, but your risk tolerance may dictate that you not exceed a stock allocation of 70%. In this case, the Target Retirement 2020 fund, with a 67% stock allocation, would be more appropriate for you, rather than the Target Retirement 2030 fund with its 82% stock allocation.

One of the changes that Vanguard will soon be making to its Target Retirement funds is increasing the allocation to international stocks from 20% to 30% of the stock portion of the portfolio. From my perspective, this makes the funds more attractive, since I personally think an allocation of at least 30% to international stocks is desirable.

Features that make the Vanguard Target Retirement funds attractive relative to competitors are low costs, indexing and simplicity. Expense ratios are about 0.2%, and the underlying funds are other Vanguard index funds. After the upcoming changes, most of the Vanguard Target Retirement funds will consist of 3 Vanguard Index funds:

  • Total Stock Market Index Fund
  • Total International Stock Index Fund
  • Total Bond Market II Index Fund

By contrast, target-date funds from other companies have higher expenses, include actively-managed funds, and are quite complex, often consisting of 10 to 20 other funds (making it hard to figure out exactly what the asset allocation is). Nevertheless, a target-date fund from another company still may be a reasonable choice in your 401(k) or 403(b) plan, where you don’t have access to Vanguard funds. For example, in a 401(k) I was recently looking at, the target-date funds had an expense ratio of about 0.65% and included about 10 funds, but the diversification was pretty good, and 0.65% is much less than other 401(k) choices I’ve seen. For the person involved, with no investment experience or knowledge, this fund probably is the most appropriate choice.

Target-date funds have some issues, and may not be the best choice for someone who is willing to spend time learning about investing and managing their investments. For example, if you have investments in both taxable and tax-privileged accounts (e.g., IRA, 401k), then it generally is preferable to hold bonds in the tax-privileged accounts and stocks in the taxable accounts. This obviously can’t be done with a single fund. However, if most of your investments are in a tax-privileged account, you just don’t want to mess around with more complexity, and you have access to a decent target-date fund, then a target-date fund with an allocation that’s appropriate for your risk tolerance may be the way to go.


  1. So this option is basically for novel investors who don't really know much about asset allocation, right? For those of us who already have multiple asset allocations, would it be best to take a bit more risk and invest in stocks/bonds that best meet our target international/U.S. allocation percentages?

    Great to at least know about this option for new investors!

  2. Kristen,

    Yes, this option is probably a good one for novice investors, but also for anyone who just doesn't want to spend much time or energy on managing their investments.

    For those of us who are already managing a portfolio of multiple asset classes, and who are willing to deal with the additional complexity, no one can say definitively that we will be better off. We aren't necessarily taking more risk. For example, I don't invest in a target-date fund, but my portfolio is lower risk than a young person investing in say a Target Retirement 2030 fund, because my allocation to stocks is lower, due to my lower need to take risk to achieve my investment goals. However, you could say that you, for example, are taking more risk because of your higher allocation to small and value stocks, relative to a typical target-date fund. Although there's never any certainty in investing, the studies indicate that fine tuning your asset allocation beyond that of a typical target-date fund is likely (but not certain) to provide a higher return in the long run.

    Obviously I feel that what we're doing now with your portfolio is better than using a target-date fund, but we always should remind ourselves that we really don't know what will end up being the best investment stategy over the next 20 or 30 years. A novice investor using a target-date fund could end up doing better than a more knowledgeable investor using a more complex asset allocation. We each have to just learn as much as we're willing to, then make a decision as to which way we want to go.