roll your own target date fund, part 4: the funds

Alright, now it’s time to get down to the nitty gritty. You’ve decided on an allocation and you’ve decided on a location. Now for the big question: what funds do you actually buy? As it turns out, this part is actually simpler than you might think. There are two main rules:

#1: Follow your allocation. This means avoiding funds that are mixes of different asset classes, which includes most actively-managed funds, since they almost always contain some amount of cash.

#2: Find the lowest expense ratio possible. Forget Morningstar ratings; within a given asset class, expense ratio is the best predictor of fund performance. Now, this is simultaneously intuitive and counter-intuitive — one would expect a cheaper investment to be a better bargain, but at the same time, one would expect someone who charges more to give you more for your money. That’s certainly what expensive funds would like you to believe, but the research — including Morningstar’s own! — doesn’t bear that out.

With those two rules in mind, let’s take a look at 401(k)’s and IRA’s.

401(k)’s

With 401(k)’s (and 529’s), rule #1 is generally enough to suffice: you rarely have more than one fund per asset class, which makes the choice easy. However, sometimes there’s no direct match, in which case you just do the best you can. Here’s a list of funds you might swap out a given asset class for, in order of preference:

  • Large Cap -> Total US Stock -> Total World Stock
  • Large Cap Value -> Large Cap -> Total US Stock -> Total World Stock
  • Small Cap -> Total US Stock -> Large Cap Value -> Large Cap -> Total World Stock
  • Small Cap Value -> Small Cap -> Total US Stock Index -> Large Cap Value -> Large Cap -> Total World Stock
  • REIT -> Large Cap -> Total US Stock -> Total World Stock
  • International Developed -> Total Ex-US Stock -> International Large Cap -> Total World Stock
  • International Small-Cap -> International Developed -> Total Ex-US Stock -> International Large Cap -> Total World Stock
  • International Emerging Markets -> International Small-Cap -> International Developed -> Total Ex-US Stock -> International Large Cap -> Total World Stock
  • Intermediate-Term Bond -> Total US Bond
  • Short-Term Bond -> Intermediate-Term Bond -> Total US Bond
  • Inflation-protected Bond -> Short-Term Bond -> Intermediate-Term Bond -> Total US Bond

IRA’s

Now, with an IRA, your choices are much, much broader, bordering on overwhelming. However, given that the ideal per the above rules is (a) a “pure” mutual fund, and (b) an inexpensive one, the choice becomes clear: Vanguard index funds. You can easily find an index fund that matches any of the given categories above, and it is virtually guaranteed to have the lowest expense ratio in its class. Also, you can avoid brokerage fees by opening your IRA with Vanguard itself. The only caveat is that Vanguard funds often have a minimum ($3,000 is the most common). If you have less than this, you can substitute funds as per above; for example, you could combine all of your stocks into Total World Stock and all your bonds into Total US Bond.

(Sounds like an advertisement, I know. But Vanguard doesn’t know me from Adam. I just like their funds.)

That’s it — you’re done! Once you’ve come up with your allocation, all you have to do is rebalance periodically to stick with your target (and update your target as circumstances change). More on that in a future post.

In the meantime, if there’s a related topic you’d like me to go over in detail, let me know in the comments!

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3 thoughts on “roll your own target date fund, part 4: the funds

  1. I’ve been getting increasingly concerned about index funds (see ‘Index Premium’ here: http://www.petajisto.net/research.html ). Essentially, companies go up in value significantly just by being added to an index – he puts it at about 8%. This is a type of bubble and likely adds volatility to index funds, and might be a contributing reason why index funds haved outperformed actively managed funds (obviously, this will disappear over time).

    Also, see his more recent papers on Index funds vs. actively managed funds (just went to his site for the first time in years). It’s not so clear cut that index funds are always better.

  2. The Index Premium paper is fascinating. I don’t doubt that being added to an index such as the S&P500 or Russell 2000 introduces a premium to a stock value’s price. I’m also willing to believe his thesis that this premium introduces a drag onto those indices’ performance. I have several responses, in no particular order:

    Your last sentence is entirely accurate: index funds are not, in fact, always better. No one fund is always the best in its class, due to the fact that investing relies entirely on predicting the future, which, as Master Yoda tells us, always in motion is. The question is which fund has the best *likelihood* of outperforming (even after the dragging effect of index premia!), and until research shows an actively managed fund being more likely to outperform than a passive, or that there’s a metric that predicts in-class fund performance better than cost, I’ll continue to recommend index funds.

    One of Petajisto’s suggestions to counter the index premium’s effect is to own the entire (say) U.S. stock market, rather than just the S&P500. This is a good idea.

    Petjisto also notes that the index premia have been “growing over time, peaking in 2000, and declining since then”. This supports your earlier statement that an index premium “bubble” would disappear over time, as the market moved to arbitrage the inefficiency away. Arbitrageurs are very good at their jobs, and the profit for being able to effectively do so is immense — much more so than for being an index manager, closet or otherwise — so there will always be forces acting to drain this particular bubble.

    Finally, note that this is all just a starting point — ideas that will get you 90% of the way there, so that you’re actually investing rather than waiting to find the Perfect Investment (not to mention biting your nails over your investment’s performance). Until we find a true crystal ball, all we can do is go with the best statistical likelihood and focus on what we can best control and predict. After all, there are much more important factors than whether you choose VLCAX or DODGX — how much you invest and how early you start, for example: http://financialgeekery.com/2012/04/17/some-perspective-on-investment-choices/.

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