Should investors create their own target date fund?

Target date retirement funds are often found in 401 (k) companies, IRAs, and other investment vehicles. But many investors in such funds wonder if they could not achieve similar or better returns by creating replicas, at no cost.

We did a little test and found that as long as you have the time and diligence to monitor and adjust your portfolio over time, then yes, the do-it-yourself version on average outperforms the target date fund of. origin by eliminating its fees and expenses.

A target date fund is most often a mix of stocks and bonds in which the allocation of investments shifts from riskier to more conservative as the investor’s year of retirement approaches. An investor preparing to retire in 2040, the current average year for all target date retirement funds, can save an average of 0.14 percentage points in expenses and fees per year, which translates to more than 2 percentage points of cumulative return over a 10-year period.

And, even better, if you’re a younger investor with an approximate retirement date of 2060, you can save an average of 0.17 percentage point in fees per year, which can generate an increase of over 3 percentage points. cumulative returns over 10 year period.

To implement this study, my research assistant Tyler Harb and I first collected allocation data from the prospectuses of all US-based target date retirement mutual funds. Many were very specific about what they were invested in (other mutual funds, mainly) and the importance of the allocation. Some have been unwilling to reveal the names of the funds they have invested in, but have described them in terms specific enough that we can identify them as, say, a large or mid-cap US equity fund. Using this data, for each target date fund, we created a replica fund with the same content and allocations, and then ran market simulations to see what kind of return an investor would get using a version. DIY compared to its original.

To give each target date fund a chance to fight back against its aftershock, we have chosen its cheapest option among different share classes. For the funds that we have placed in the replicas, we have chosen the share class with the most assets under management. We then assigned each investment within the replicas the same weight as that present in the original fund.

Benefits for young investors

The first interesting result is that, on average, an investor in a 2040 target date branded fund can expect to pay an expense ratio of around 0.32 percentage point per year. But if investors wanted to build the same fund (using the same mutual fund offerings), they could do so for around 0.18 percentage point per year. This equates to an excess return of 2.5 percentage points over a 10-year period.

The second interesting finding is that for longer-term retirement funds, for young people who will not retire for decades, savings are even more important.

DIY pays off

Excess returns that can be obtained by “doing it yourself” instead of buying the fund at maturity.

Excess return over a 10-year period

Expense ratio for the fund at maturity

Matched do-it-yourself fund expense ratio

10-year excess returns, per targeted retirement year

2020

2025

2030

2035

2040

2045

2050

2055

2060

Investors who buy a 2060 target date branded fund can expect to pay an expense ratio of 0.34 percentage points per year. If they build the same underlying fund, they could do so for an average of 0.17 percentage points per year (using the same fund family offerings). This equates to an increase of more than 3 percentage points in returns over a 10-year period.

One factor in this advantage for young investors is that as a fund’s retirement date advances into the future, the fund manager avoids short-term debt, inflation-protected bond funds. and high dividend stocks for large caps. equity, international equity and small-cap equity funds. This difference in ownership allows the investor on average to save a few hundredths of a percentage point on expense ratios. The second factor is that as a fund’s retirement date lengthens, the fund family charges more for that product, perhaps because younger investors are less price sensitive when it comes to savings. ‘invest.

A positive

As for the positive side of target date funds, 10% of the funds in our sample were actually sold ‘at cost’, meaning that the target date retirement fund expense ratio was the weighted average of the components. underlying. Thus, an investor would not save money by trying to replicate these target date funds.

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On the flip side, over 10% of target date funds had an expense ratio greater than 0.60 percentage point per year compared to the DIY portfolio. The result: investors replicating the target date fund would earn more than 10% additional returns over a 10-year period.

Overall, adventurous and diligent investors (especially young investors) should note the cost savings of starting their own fund. Of course, the downside to doing it yourself is the desire to time the markets and rebalance too often. But if you can control that urge, a DIY portfolio can earn you a few percentage points in retirement.

Dr Horstmeyer is Professor of Finance at George Mason University’s Business School in Fairfax, Virginia. We can reach him at [email protected].

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