Another Reason Why Vanguard Target Retirement Funds Are Underrated

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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.

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  1. Thank for writing about this–I rolled over a 401(k) from a previous job in to a Vanguard Target Retirement fund IRA a few weeks ago because I don’t have a current 401(k) available. I picked Vanguard based on the good things that you said about them and for their low expense ratio philosophy. I went with a Target Retirement fund over a mix of index funds because I just don’t have time or the interest in rebalancing my investments periodically.

  2. I’ve invested in the Vanguard 2050 fund since it’s inception and I can’t complain. I’ve opened a money market account to invest in ETFs and add a little more diversity to my IRA holdings, but never transferred any funds. These funds are just so easy to set and forget. The only thing I do not like about them is they hold 10% bonds. At my age (30) that’s 10% to much. I also don’t like the equity glide path. The fund starts selling off equity in exchange for bonds a little too early (2025). By 2035 (15 years to retirement), it’s over 25% bonds, which is still to high IMO.

    I eventually want to sell off my VFIFX holdings and create my own portfolio that will closely mirror VFIFX, but instead of bonds will hold a REIT sector ETF for added diversity.

  3. Another way of looking at the investor return vs. total return figures would be to simply observe that the average investor in the target date funds has “done better” than the average investor in a stock index fund, relative to the underlying total return of the respective funds.

    This speaks less to target date funds’ “performance” (they are, after all, just funds of funds) than to their suitability as an investing instrument. I agree with Jonathan’s observations that they are good for most people — and one could certainly do worse!

    One deficiency here may be our ability to clearly define what we’re measuring. For example, perhaps it would be more appropriate to compare the “investor return” of a target date portfolio with the “investor return” obtained by an investor holding a similar balanced portfolio of the underlying funds (rather than just look at inflows and outflows from the stock fund). This is much harder to do, of course, and basically requires that you stay in the realm of the hypothetical.

    A hypothetical investor could mimic the target fund and achieve better results with the underlying funds (due to lower expense ratios), but how often will this happen in practice? For a relatively small percentage of disciplined investors (the kind with a written investment policy), a DIY portfolio is probably the way to go. For most everybody else, a target date fund is quite suitable, and will hopefully provide a measure of protection from one’s own potentially counterproductive behaviors.

  4. Misleading article. Initially I thought the blog entry is about the expense ratio. But no. The difference between the fund return and average investor return has to do with the investor rather than the fund itself.

    Rather than advising the reader to purchase target retirement fund, you should perhaps point out ‘timing the market’ is bad.

    VFINX has provided a much better return over VTIVX over time if one had stayed invested.

    • I’m not sure why you would find it misleading, other than your own preconceptions. I never really mentioned expense ratio at all.

      I agree the gap is behavioral, and thus the reason for the good investor performance in Target Retirement Funds is behavioral. But same investors can buy each fund, so perhaps Target funds provide a structure that encourages the proper behavior. It’s similar to “eating junk food is bad” vs advice on incorporating barriers to junk food access in your life.

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