When I started my first 401k about three years ago, I was boggled by the fund choices given to me. I ended up picking the Fidelity Freedom 2040 Fund (FFFFX), probably for the reason most people do – it looked simple and had tons of funds with great sounding names in it. Disciplined Equity? Value? Growth and Income? They all sounded pretty good to me. Who doesn’t want some discplined investing, value, or growth?
But what are you really buying? If you read its information page you see that this fund of funds includes 17 different stock funds and 6 different bond funds:
Fidelity Growth & Income Portfolio 11.15%
Fidelity Blue Chip Growth Fund 10.06%
Fidelity Equity-Income Fund 10.04%
Fidelity Disciplined Equity Fund 10.03%
Fidelity Mid-Cap Stock Fund 6.44%
Fidelity Growth Company Fund 6.44%
Fidelity Europe Fund 5.55%
Fidelity OTC Portfolio 5.12%
Fidelity Overseas Fund 4.13%
Fidelity Diversified International Fund 4.10%
Fidelity Value Fund 3.80%
Fidelity Fund 3.55%
Fidelity Japan Fund 1.74%
Fidelity Small Cap Independence Fund 1.40%
Fidelity Southeast Asia Fund 0.82%
Fidelity Small Cap Growth Fund 0.35%
Fidelity Small Cap Value Fund 0.35%
Fidelity Capital & Income Fund 4.96%
Fidelity High Income Fund 4.93%
Fidelity Investment Grade Bond Fund 1.84%
Fidelity Government Income Fund 1.70%
Fidelity Intermediate Bond Fund 1.17%
Fidelity Strategic Real Return Fund 0.28%
While you do get a good amount of diversification in a simple package, I would note that these are all actively-managed funds, there is not one index fund in the bunch. Some of these funds have good track records, and some don’t. I would pose that Fidelity possibly sneaks in some of their more profitable funds (does having 0.28% of any fund really matter?). The actively-managed funds, although no-load, lead to an annual expense ratio of 0.76%. Not good, but not atrocious.
There is also a certain amount of overlap between all the funds. If you use Morningstar X-Ray, it is revealed that the overall breakdown is approximately
65% US Stocks (primarily Large Cap)
20% International Stocks
What about past performance?
I don’t usually put too weight on recent performance, but Fidelity has made it’s own comparison index called the Fidelity Freedom 2040 Composite Index which is made up of unmanaged indices like the Wilshire 5000. Note that the actual 5-year performance (3.94%) lags the index performance (4.88%) by 0.94%, about the same as the expense ratio which in previous years has been at about 0.90% (higher than now).
This is exactly what a lot of academic research has shown – over time, actively managed funds lag the corresponding indices by the exact amount of their expense ratio. Thus, the most important thing is to work to minimize that expense ratio!
Roll your own?
One great thing about 401ks is that you (usually) don’t have to worry about low-balance fees. You could have $24 in a fund and you’d be fine, because across all the 401ks in your company, Fidelity has enough money pooled together so they don’t care. That’s one drawback of an Self-Employed Solo 401k – you do have balance requirements to maintain.
So what if you just modelled your portfolio after the asset allocation of this fund, using the index funds available to you? Sure, you’d have to rebalance yourself, but you can use the Freedom funds as a guide, and you’d only need to do it once every one or two years.
Here’s a quick possiblity using the index funds available in my wife’s 401k:
50% Fidelity Spartan US Equity Index Fund (FUSEX)
15% Fidelity Spartan Extended Market Index Fund (FSEMX)
20% Fidelity Spartan International Index Fund (FSIIX)
15% Fidelity US Bond Index Fund (FBIDX)
Using Morningstar X-Ray again, one can see that this breakdown gives a similar asset allocation mix to the Fidelity 2040 Funds, but has a combined annual expense ratio of only 0.13%, thanks to the super-low expense ratios of Fidelity’s index funds. That’s a difference of 0.63%, which if that is the amount that it will outperform FFFFX annually in the long run, is a big difference indeed.
Added: If you take the 5-year performance of the above mix of index funds and do not rebalance (for simplicity since I don’t have the performance for each individual year), you get a 4.78% return, beating FFFFX and which is .10% off of the 4.88% theoretical index return, very close to the 0.13% expense ratio.
My opinion remains that Fidelity’s Freedom Funds are an “okay” place for people who have a Fidelity 401k and really don’t want to think about their investments and just want one fund to do it all for them. It is automatically rebalanced as you age and the expense ratio of 0.76% is below industry average.
However, with just a little bit of do-it-yourself gusto, you can imitate the Freedom fund but still get a significantly lower expense ratio and an equal (if not greater) amount of diversification using Fidelity’s low-cost index funds.
The question is – Can you spare the extra hour (if that) a year to rebalance?
(The third option, as always, is to do some reading and make your own portfolio decisions.)