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VFORX: How A Target Date Fund Should Be Built

Summary The Vanguard Target Retirement 2040 Fund has a simple construction and a low expense ratio. Despite being a very simple portfolio, they have covered exposure to most of the important asset classes to reach the efficient frontier. The fund is mostly in equity but has materially underperformed the S&P 500 over because of a strong allocation to international equity. Lately I have been doing some research on target date retirement funds. Despite the concept of a target date retirement fund being fairly simple, the investment options appear to vary quite dramatically in quality. Some of the funds have dramatically more complex holdings consisting with a high volume of various funds while others use only a few funds and yet achieve excellent diversification. My goal is help investors recognize which funds are the most useful tools for planning for retirement. In this article I’m focusing on the Vanguard Target Retirement 2040 Fund Inv (MUTF: VFORX ). What do funds like VFORX do? They establish a portfolio based on a hypothetical start to retirement period. The portfolios are generally going to be designed under Modern Portfolio Theory so the goal is to maximize the expected return relative to the amount of risk the portfolio takes on. As investors are approaching retirement it is assumed that their risk tolerance will be decreasing and thus the holdings of the fund should become more conservative over time. That won’t be the case for every investor, but it is a reasonable starting place for creating a retirement option when each investor cannot be surveyed about their own unique risk tolerances. Therefore, the holdings of VFORX should be more aggressive now than they would be 3 years from now, but at all points we would expect the fund to be more conservative than a fund designed for investors that are expected to retire 5 years later. What Must Investors Know? The most important things to know about the funds are the expenses and either the individual holdings or the volatility of the portfolio as a whole. Regardless of the planned retirement date, high expense ratios are a problem. Depending on the individual, they may wish to modify their portfolio to be more or less aggressive than the holdings of VFORX. Expense Ratio The expense ratio of Vanguard Target Retirement 2040 Fund is .18%. That is higher than some of the underlying funds, but overall this is a very reasonable expense ratio for a fund that is creating an exceptionally efficient portfolio for investors and rebalancing it over time to reflect a reduced risk tolerance as investors get closer to retirement. In short, this is a very solid value for investors that don’t want to be constantly actively management their portfolio. Composition The fund is running almost 89% stocks to about 11% bonds, but over time the portfolio shifts to sell off stocks and hold more bonds as Vanguard assumes that investors nearing retirement will have a reduced risk tolerance. This portfolio strategy is the embodiment of what financial advisors seek to do for clients. Unfortunately Vanguard does not know the unique circumstances of every client, but for a .18% expense ratio they are doing a great job. Holdings The following chart demonstrates the holdings of the Vanguard Target Retirement 2040 Fund: (click to enlarge) This is a fairly simple portfolio. Only four total funds are included so the fund can gradually be shifted to more conservative allocations by making small decreases in equity weightings and increases in bond weightings. The funds included are the kind of funds you would expect from Vanguard. They are all solid funds with strong internal diversification in the holdings and low expense ratios. The Vanguard Total Stock Market Index Fund is also available as an ETF. The ETF version is the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). To be fair, Vanguard has a great reputation for running funds but not for coming up with creative names. I have a significant position in VTI because it carries an extremely low expense ratio and offers excellent diversification across the U.S. economy. Volatility An investor may choose to use VFORX in an employer sponsored account (if their employer has it on the approved list) while creating their own portfolio in separate accounts. Since I can’t predict what investors will choose to combine with the fund, I analyze it as being an entire portfolio. Since the fund includes domestic and international exposure to both equity and bonds, that seems like a fair way to analyze it. (click to enlarge) When we look at the volatility on VFORX, it is only slightly lower than the volatility on SPY. Despite similar levels of volatility, it has underperformed SPY. Generally investors will expect a target date fund to hold up better in a bear market and to fall behind in a bull market. For a portfolio with a target date as distant as 2040, investors have to expect strong equity positions will result in similar returns to the market. The real weakness demonstrated here was largely a function of the international equity markets underperforming the domestic equity markets. A Suggested Modification Even though this portfolio is designed for investors that are 25 years away from retirement, for the sake of lower annualized volatility I would like to see a slightly larger allocation to very long term treasury bonds. Since Vanguard is regularly rebalancing the fund it should be able to benefit from the strong negative correlation between the domestic equity market and the long term treasuries. To be fair, international markets have also been showing a negative correlation with long term treasury returns, so it really should be able to dramatically reduce the volatility without creating a very large drag on earnings. The benefit of the negative correlation with frequent rebalancing allows investors to be regularly buying low and selling high. Compared to most active investment strategies, a simple rebalancing plan that combines long term treasuries with domestic equities has been a very solid and remarkably simple strategy. Conclusion VFORX is a great mutual fund for investors looking for a simple “set it and forget it” option for their employer sponsored retirement accounts. It is ideally designed for investors planning to retire around 2040, but can also be used by younger employees with lower risk tolerances or older workers with higher risk tolerances.

LQD: This Huge Bond Fund Looks Very Solid

Summary LQD offers investors exposure primarily to the 3 to 10 year portion of the bond market with 27% going to the very long portion of the yield curve. Allocations to the very long end of the yield curve (over 20 years) combine with investment grade credit quality to create negative correlation with the S&P 500. The expense ratio is a little higher than I like to see, but it isn’t too bad. Compared to a large bid-ask spread on other bond ETFs, total ownership cost should be attractive. It appears the fund has free trading through TD Ameritrade and Fidelity. The iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ) is a huge bond ETF. The ETF has around $24 billion in assets under management. While the additional size may not be a substantial factor for shareholders, the average trading volume over 900,000 shares translates into around $10 million per day. For investors that want to be able to move in and out of the bond market, high liquidity is a huge advantage since it reduces the bid-ask spread. Expenses The expense ratio for LQD is.15%. This isn’t the best expense ratio an investor can find, but isn’t too high either. The real question here is how long an investor would plan to hold the fund. If the holding period is several years then there is an advantage to going for a rock bottom expense ratio. Some of the smaller bond ETFs have demonstrated bid-ask spreads greater than 1%. That can be a real pain. Crossing that bid-ask spread once would be equivalent to the expense ratio for 7 years. Add in that investors are only going to save a few basis points and there are some material advantages from the better liquidity of LQD. Yield The yield is 3.46%. It isn’t very high, but as you’ll see when we go through the portfolio this is investment grade corporate debt with only moderate duration exposure. Duration The following chart demonstrates the sector exposure for this bond fund: This is a fairly nice collection. The fund is pretty much excluding short duration bonds that have fairly weak interest rates in favor of holding those along the middle of the yield curve. To boost yields there is also a material allocation to the very long duration securities. Sectors The following chart demonstrates the sector exposure for this bond fund: I don’t see a huge problem here. The fund avoids having a huge exposure to the energy sector which is beneficial since the falling prices could trigger downgrades for several of the smaller companies in the sector. Since the fund is holding investment grade debt and has an enormous amount of assets, having to sell off bonds from a smaller issuer after a downgrade could push the price of those bonds down due to illiquidity of the underlying bonds. The allocation list goes on to include several incredibly tiny sector allocations. If you wish to see the full list, it is available on the fund’s website . Credit The next major issue to look at is the credit rating of the companies in the fund. The debt is investment grade, but the fund is walking the line in that regard to generate higher yields. As long as the management is watching the underlying liquidity, I don’t see a problem. Notice that there is a very little investment in AAA rated debt. This fund intends to take on some credit risk to enhance returns, but it doesn’t intend to take on much. For the investor seeking stronger yields than treasuries can provide without the credit risk of junk bond funds, this is a fairly reasonable compromise. By focusing on investment grade debt and incorporating some longer maturities the fund retains a negative correlation with the S&P 500. Over the last 2 years that correlation was -.15. For the investor that likes to rebalance their holdings occasionally and values negative correlation for the market the liquidity here really shines. Conclusion Overall this is a fairly solid bond fund. The duration risk is not overwhelming, but it is enough to generate negative correlation to the broader stock market. For any shorter term bond investments, the liquidity here trumps the difference in expense ratios. I did a quick search on brokerages with free trading on the ETF since an investor planning to rebalance or adjust their position frequently would want to avoid commissions. It appears TD Ameritrade and Fidelity are offering commission free trading on LQD. I’m giving this bond fund a 9.5/10 rating. If the expense ratio dipped under .10%, it would be a very solid 10.

The V20 Portfolio Week #12: The Value Of Doing Nothing

Summary The V20 Portfolio increased by 5% while the S&P 500 rose 3%. Doing “nothing” has value. Dex Media and Conn’s should release material news in January. Things are looking up as we wrap up the year. The recent rally sent the S&P 500 into positive territory for the year, and the V20 Portfolio benefited as well. Although the market closed early this week, the V20 Portfolio posted a respectable gain of 5% versus S&P’s gain of 3%. There were no major news for any of our holdings and there were no major movers. Quite a boring (but profitable) week I would say. At times like this, I feel that it’s important to review the V20 Portfolio’s philosophy. Doing Nothing In 2015, the V20 Portfolio only entered into seven positions and only completely exited one (Perion Network (NASDAQ: PERI )). To some, this may seem lazy. “What? The Traveling Investor only studied seven stocks and called it a year?” Rest assured that a lot more work was being done behind the scene, much of which I’ve shared with the Seeking Alpha community, such as my Low P/E series or Diamond, Rock, Or Coal series . However, that is not the point. What I’m really trying to say is that there is value in doing “nothing.” When you know that your portfolio contains the best stocks (out of the ones you’ve studied), what’s the benefit of replacing one? There is none. While I’ve looked at hundreds and hundreds of stocks, none of them made the cut to supplant any of our current holdings (including cash). Of course, the reason why it is difficult is the result of V20 Portfolio’s high return objective. It is quite easy to identify a stable company that can return 3% annually, but it’s quite another story to spot a company that can return 20% with reasonable certainty over the long-term. Near-Term Outlook I’ll talk about some near-term catalysts that could impact the V20 Portfolio in the near-term and I’ll save the discussion of 2016 for next week. Dex Media (NASDAQ: DXM ) is nearing its third deadline. After two extensions of the forbearance period, we should receive another update by January 4th, 2016. There is no doubt that any news, both good and bad, will introduce significant volatility to the stock. However, from the portfolio’s perspective, the volatility is restricted to the upside. As of December 24th, 2015, the position only accounted for 0.5% of the total portfolio. Conn’s (NASDAQ: CONN ) will be releasing December 2015 sales data in January. Recently there has been some weakness the retail sector due to poor industry data. U.S. retail sales were below forecasts for the last three reporting periods (September to November). While Conn’s has continued to churn our very good numbers (November comps were up 8%), it is clear that the market is still betting against it given the way the stock has been performing (down almost 50% from its high in July). While I do not think that comps growth can stay elevated at 8% forever (and I don’t think any retailer is capable of such a feat), I do believe that Conn’s will not experience a sales meltdown that many investors have been fearing since it started to tighten its credit policy, and December sales data could be data that can revert investors’ current pessimism. Note: I spend a great deal of time researching every company in the V20 Portfolio (~40% YTD). If you are looking for some ideas that could complement your own portfolio, you can click the “follow” button and be updated with my latest insights. Premium subscribers will get full access to the V20 Portfolio. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.