Target date mutual funds are portfolios of funds that adjust the allocation to stocks and bonds based on how close the fund is to its specific target date. These funds are, in theory, great for people saving for retirement, as they gradually reduce the risk exposure of the fund as the retirement date gets closer. By buying a target date fund, the retiree doesn't have to worry about rebalancing his/her portfolio each year.
This article explains the idea pretty nicely and contains a graphic showing how the allocations might change over time.
So what's not to love about target date funds? A lot actually. Ron Elmer has done a nice investigation of exactly what goes into one of these funds. You can read it here. The analogy I'd like to make is one of making hotdogs. The good cuts of meat (the good funds) are generally sold directly to the public, but the nasty stuff is mushed up and put into hotdogs (target date funds). To understand why this is so, you need to know a little bit about how mutual funds come and go.
Most mutual fund companies are constantly starting new funds. But no one wants to put money in these new funds because they don't have a track record. In addition, because they are small, their expense ratios are often pretty high. But the mutual fund company can stick these start up funds in a target date fund. Because people buy the target date fund without paying attention to the funds within the fund, they will put money into these start up funds. The start ups that do well will most likely be sold directly to investors (these turn out the be the good cuts), but the ones that do badly will be closed or folded into other funds and replaced with a new startup.
As a result, at least for the target date fund that Ron looked at, the fund is heavily weighted towards new, high fee funds that have poor track records. Case in point, the Fidelity Freedom 2035 fund has an expense ratio of 0.77% which is basically the average of the funds it contains. This is much higher than the expense ratio of an equivalent portfolio of index funds.
As a side note, the Fidelity Freedom 2035 fund is one of the options offered to employees at my institution.
Showing posts with label 401K Cookbook. Show all posts
Showing posts with label 401K Cookbook. Show all posts
Thursday, February 16, 2012
Thursday, November 17, 2011
Tuesday, April 19, 2011
Diversification by Omission?
Ken French talks about the effect of omission on diversification.
Key point - its not just all about correlations. Raw variances matter too.
The idea of bets by omission is a really important one and something I recently talked about with Ron Elmer who is the author of "The 401K Cook Book". Ron's point is that many portfolio managers who are benchmarked against the S&P 500 hold only a fraction of the 500 stocks in the index. Perhaps the stocks that they hold are the ones that they feel most strongly about. Or perhaps they just don't have the man power to examine all 500 stocks. Either way, the stocks that they don't hold actually represent a bet against those stocks. In effect they are underweight those stocks.
We should be very careful to think about what we are not including in our portfolios because these "omissions" actually represent unintended bets against those securities.
Key point - its not just all about correlations. Raw variances matter too.
The idea of bets by omission is a really important one and something I recently talked about with Ron Elmer who is the author of "The 401K Cook Book". Ron's point is that many portfolio managers who are benchmarked against the S&P 500 hold only a fraction of the 500 stocks in the index. Perhaps the stocks that they hold are the ones that they feel most strongly about. Or perhaps they just don't have the man power to examine all 500 stocks. Either way, the stocks that they don't hold actually represent a bet against those stocks. In effect they are underweight those stocks.
We should be very careful to think about what we are not including in our portfolios because these "omissions" actually represent unintended bets against those securities.
Friday, January 7, 2011
401K Cookbook.
In full disclosure, this is a blatant plug for a friends book, but I highly recommend it to anyone who is trying to figure out what they should do with the funds in their 401K plan.
The 401K Cookbook is just that. A cookbook. The basic premise is that if you want to make brownies you don't need to know how sugar and flour chemically bond with water and chocolate to create yummy brownies, all you need to know is what proportions to put in the mixing bowl. The same logic applies to retirement investing. You don't need to know about portfolio theory, risk premiums, efficient frontiers, you just need to know where to put your money and be done with it.
The 401K Cookbook starts off with a little test that tries to figure out your true investing age. If you are more risk averse, your investing age will be higher, if you are less risk averse your age will be lower. You then turn to the page for your investing age and use the allocations that are presented there. It's that simple.
Once you've created your portfolio, you just need to come back in a year or two and re-take the test and tweak the weights. The whole process shouldn't take more than a couple of hours. But if you want to learn more about the logic behind the asset allocations, you can read the back 1/3 of the book which provides a crash course in retirement investing.
Ron Elmer, the author, has a long experience in money management. He's also a big advocate of indexing. He saw a need for a simple, straightforward book that people could use to set up their portfolios. As one didn't exist in the marketplace, he decided to write and publish it himself.
Ron is working on further versions of the book that deal with specific fund companies such as Vanguard and Fidelity.
The 401K Cookbook is just that. A cookbook. The basic premise is that if you want to make brownies you don't need to know how sugar and flour chemically bond with water and chocolate to create yummy brownies, all you need to know is what proportions to put in the mixing bowl. The same logic applies to retirement investing. You don't need to know about portfolio theory, risk premiums, efficient frontiers, you just need to know where to put your money and be done with it.
The 401K Cookbook starts off with a little test that tries to figure out your true investing age. If you are more risk averse, your investing age will be higher, if you are less risk averse your age will be lower. You then turn to the page for your investing age and use the allocations that are presented there. It's that simple.
Once you've created your portfolio, you just need to come back in a year or two and re-take the test and tweak the weights. The whole process shouldn't take more than a couple of hours. But if you want to learn more about the logic behind the asset allocations, you can read the back 1/3 of the book which provides a crash course in retirement investing.
Ron Elmer, the author, has a long experience in money management. He's also a big advocate of indexing. He saw a need for a simple, straightforward book that people could use to set up their portfolios. As one didn't exist in the marketplace, he decided to write and publish it himself.
Ron is working on further versions of the book that deal with specific fund companies such as Vanguard and Fidelity.
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