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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. Scalper1 News
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