Build your own target-date fund

Are you investing in a target-date mutual fund?

If so, you might want to reconsider doing so – especially given the expense of these funds.

So say the authors of a new research paper, Off Target: On the Underperformance of Target-Date Funds.

According to the authors, David Brown, an assistant professor at University of Arizona and Shaun Davies, an assistant professor at the University of Colorado at Boulder, “target-date funds (TDFs) are popular vehicles that provide investors with an evolving asset allocation to meet their needs at some future date – retirement for example.”

But even though TDFs provide investors with extensive diversification and active rebalancing, the authors noted that TDFs are also a type of fund-of-funds. “As such, investors pay multiple layers of fees as most TDFs charge fund-of-funds’ fees and also hold funds that collect additional fees,” they wrote.

In fact, Brown and Davies’ analysis shows that TDF sponsors collectively charged nearly $2.5 billion in excess fees in 2017 alone.

Build Your Own

Given that, Brown and Davies present an alternative to using high-cost TDFS. In their paper, Brown and Davies show that TDFs are easy to emulate with a portfolio of cost-efficient exchange-traded funds (ETFs) and they’ve coined these portfolios Replicating Funds or RFs.

According to their research, “RFs substantially outperform TDFs, exhibit low tracking error, do not suffer from cash drag, and require infrequent rebalancing.”

In an interview, Brown and Davies said they initially set out to help people like their parents and relatives and others, many of whom might be saving for retirement using a TDF. “It’s a very attractive vehicle” but it can be “very opaque in terms of what you are paying for,” Davies said.

Typically, he said, you’re paying a management fee at the parent level and another fee at the fund level.

And in their study, they show how a portfolio of low-cost ETFs that replicate the mutual funds in a target date fund (RFs) substantially outperform the TDF by 25% over a 40-year period, in large part due to the cost savings. Plus, the tracking error is minimal.

“You basically are getting the same exposure to equities and bonds as you would through the target date fund,” said Davies. “But importantly, there is substantial fee savings. Again, while the fees may seem small over a lifetime, they can add up a lot.”

Of course, to make this work, 401(k) plan participants will need to create a portfolio of low-cost ETFs inside their 401(k). In their research, Brown and Davies have created boilerplate portfolios for investors that would otherwise choose a TDF simply based on its target-date (e.g., a 2030 fund).

They call these portfolios Passive Replication of Funds or PROFs. And according to the paper, PROFs outperform aggregate TDF portfolios and provide investors with practical alternatives to existing TDFs. In fact, PROFs outperformed aggregate TDF portfolios by between 0.82% and 1.07% per year while limiting excess risk.

So, for instance, if you were trying to replicate a 2030 TDF with a PROF portfolio of six ETFs, you would allocate your assets in the following manner: 44.5% in Total Stock Index (VTI); 19.04% in Total Bond Market (BND); 33.19% in Total International Stock (VXUS); 1.22% in Total International Bond (BNDX); 0.82% in TIPS (VTIP); and 1.3% in real estate (VNQ).

Of course, unlike a traditional TDF, you will have to rebalance your personalized TDF and you will have to create a glide path – the path that reduces how much is allocated to equities over time — that works for you. “Individual investors do have more work to do if they want to replicate this themselves,” said Brown. But if an investor sets up a calendar reminder to rebalance their portfolio it shouldn’t be that onerous a task.

Another challenge to implementing this strategy: A plan participant would need to access something called a brokerage window, a type of account in the 401(k) that lets the plan participant buy stocks and bonds and ETFs, to create a portfolio of replicate funds.

And that could be a problem. Few plans offer a brokerage window. “Many retirement accounts have limited—and high fee—offerings,” said Terrance Odean, a professor at University of California, Berkeley. “In many such cases, an investor won’t have the option of substituting low fee ETFs for high fee target-date funds.”

“It’s definitely a constraint,” said Davies.

But even if you can’t create a portfolio of low-cost ETFs that replicate your TDF, the research highlights the importance of benchmarking. It’s about providing some “transparency to an opaque product,” said Davies. “What you might be able to do is at least know how much you’re paying relative to an alternative, and that can then create pressure on providers to lower fees and provide some of that savings to investors.”

Of course, some fund families, much of it driven by Vanguard, according to Davies, are now creating TDFs composed of low-cost ETFs versus actively managed mutual funds. And that’s a good thing. (As a side note, Davies suggested that if you can’t build your own TDF with low-cost funds consider using Vanguard’s family of TDFs, which “is probably the best bang for your buck.”

The End Game: Lower Fees

To be fair, both Brown and Davies emphasized in the interview how much they believe TDFs are great products. “We are by no means critiquing that mechanism,” said Davies. “It is great for particularly a person that doesn’t have a whole lot of financial literacy, and isn’t quite sure how to manage a portfolio.”

Rather, Davies and Brown set out to add transparency to the product. And along the way, “hopefully bring down fees to help folks like our parents or our siblings or aunts and uncles,” said Davies.

Added Brown: “We think they’re great products, but we think they’re also generally too expensive. So lowering the fees would help everybody out and hopefully make everyone’s retirement that much more secure.”

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Original source: The Street

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