Another Reason Why Vanguard Target Retirement Funds Are Underrated

Index funds are growing increasingly popular. Yet Carl Richards tweets that over the last 15 years, the actual investor return for the popular Vanguard S&P 500 index fund (VFINX) lags nearly 2% a year behind the fund’s official return. That works out to a final balance that is 24% less. This means that if you account for the timing of actual dollar inflows and outflows, the average investor in the fund actually earned a lot less than they might think. (More explanation on investor returns vs. advertised returns here.)

Here’s the data taken straight from Morningstar. The longer the time period, the worse the relative performance:

As Abnormal Returns put it, “indexing is no panacea“. I think part of the problem is that people use the S&P 500 as a proxy for the overall stock market and thus trade it much more frequently… and poorly. If you were really afraid during the 2008 financial crisis, it was really tempting to sell your stock shares and keep it in something “safe” instead like bonds or cash. You may still be in cash today after missing out on the rebound.

But what about the Vanguard Target Retirement 20XX Funds, which are basically just a mix of different index funds? Specifically, let’s take the Vanguard Target Retirement 2045 Fund (VTIVX). It’s mostly stocks, and mostly US stocks at that, so it should behave similarly to VFINX. Check out the 10-year growth chart comparison with the S&P 500 fund:

However, the average investor returns for the Vanguard Target Retirement 2045 Fund are much closer to the fund returns. The investor return over the 10-year period is actually better than the fund return, although some of that may have to do with the small asset base in 2004.

Why is this? My opinion is that people who own the Vanguard Target Retirement fund trade a lot less frequently. Part of this is self-selection. If you buy this fund, you desire simplicity. Also, if you own an all-in-one fund that holds both stocks and bonds together, you don’t have the problem of seeing one investment drop while the other rises. This is the benefit of buying a “balanced” fund.

You won’t see Vanguard Target Retirement funds being touted very much in the financial media. Their returns are rarely at the top since they are index-based, so magazines and newsletters won’t write about them. Most advisors are supposedly charging you for their “expert” advice, so they will of course recommend something more complicated. Even index fund enthusiasts like myself often don’t invest in them because we like to fine-tune and tinker (sometimes to our detriment).

Despite their boring nature and lack of publicity, I have long recommended Vanguard Target Retirement funds to members of my family. They are simple yet diversified, have very low expenses, and designed to be left alone. You don’t even have to rebalance your holdings; it is done for you automatically. Could you do better? Maybe. Could you do worse? Definitely.

Vanguard Mutual Fund to ETF Share Conversions

If you are invested in Vanguard mutual funds, you might have been confused by their recent announcement of free trades for Vanguard ETFs for in-house brokerage customers. One consequence of this is that it makes it more attractive for many folks to convert their existing mutual funds to their respective ETF versions. Here’s what the Vanguard website has to say about it:

Can I convert conventional Vanguard mutual fund shares to Vanguard ETFs?

Shareholders of Vanguard stock index funds that offer Vanguard ETFs may convert their conventional shares to Vanguard ETFs of the same fund. This conversion is generally tax-free, although some brokerage firms may be unable to convert fractional shares, which could result in a modest taxable gain. (Four of our bond ETFs—Total Bond Market, Short-Term Bond, Intermediate-Term Bond, and Long-Term Bond—do not allow the conversion of bond index fund shares to bond ETF shares of the same fund; the other eight Vanguard bond ETFs allow conversions.)

There is no fee for Vanguard Brokerage clients to convert conventional shares to Vanguard ETFs of the same fund. Other brokerage providers may charge a fee for this service. For more information, contact your brokerage firm, or call 866-499-8473.

Once you convert from conventional shares to Vanguard ETFs, you cannot convert back to conventional shares. Also, conventional shares held through a 401(k) account cannot be converted to Vanguard ETFs.

In my opinion, the main question to ask is if you wish to buy ETFs from now on. See the Vanguard ETF vs. Mutual Fund decision process. If so, then it’s probably a good idea to convert your existing mutual funds to ETFs as well, since there is no effect tax-wise.

However, technically you could just convert your mutual funds to ETFs for the annual expense ratio savings, and then continue on buying mutual funds. Depending on the fund, the annual savings could be significant. You’ll still avoid any redemption fees, like the 0.25% that the Vanguard Emerging Markets Index Fund (VEIEX) charges. Perhaps you really like dollar-cost-averaging a fixed amount in regular intervals ($100 every two weeks, etc.).

How To Do The Conversion at Vanguard

  1. You’ll have to open a brokerage account with Vanguard, which is relatively straightforward. In the application, you’ll have to answer some employment questions and disclose any stock exchange affiliations. You’ll also choose a money market fund for your cash sweep account. See my Vanguard Brokerage opening process review for more details.
  2. Next, you should log into your mutual fund account and record the cost basis for your mutual fund shares for tax purposes. Look for the blue “Cost Basis” link when looking at your portfolio holdings. Print that page out for your records, so you know what you paid for your current holdings.
  3. Finally, you must call Vanguard and request the ETF conversion. (You can’t do it online.) The conversion will be done according to the net asset value (NAV) of the funds on the next available market close at 4pm Eastern. Approximately two days later, the new ETF shares should show up in your brokerage account. You will end up with partial shares, which can only be liquidated if you sell your entire position. It’s okay though, they still earn dividends and all that good stuff.