A target is a financial goal that an investor sets for themselves. But should investors create their own targets?
A target date fund is a mutual fund that invests in stocks and bonds with the goal of providing an income for its investors when they retire. They are typically created by financial planners to help investors plan their retirement.
401(k)s, IRAs, and other investment vehicles often include target-date retirement funds. Many investors in these funds, however, question whether they couldn’t achieve comparable or greater returns without the costs by putting up replica copies.
We conducted a test and found that, as long as you have the time and effort to monitor and modify your portfolio over time, the do-it-yourself version outperforms the original target-date fund on average by removing fees and costs.
A target-date fund is often a combination of equities and bonds in which the investment allocation shifts from riskier to safer as the client approaches retirement. An investor planning to retire in 2040—the average year for all target-date-retirement funds at the moment—can save an average of 0.14 percentage point in costs and fees each year, equating to more than 2 percentage points in cumulative gains over a 10-year period.
Even better, if you’re a younger investor with a retirement date of about 2060, you can save an average of 0.17 percentage point in fees each year, which may result in a cumulative return increase of more than 3 percentage points over a 10-year period.
To conduct this research, my research assistant Tyler Harb and I first gathered allocation data from the prospectuses of all target-date retirement mutual funds located in the United States. Many people were extremely precise about what they were investing in (mainly other mutual funds) and how much they were allocating. Some wouldn’t disclose the names of the funds they invested in, but described them in enough detail that we might recognize them as a large-cap or midcap U.S. equities fund, for example. Using this information, we built a replica fund with the identical contents and allocations for each target-date fund, then conducted market simulations to evaluate how well a DIY version would do compared to the original.
We chose the lowest-cost alternative within each share class to offer each target-date fund a fighting shot against its duplicate. We choose the share class with the highest assets under management for the funds in the sample. We then assigned the same weighting to each investment in the replicas as in the original fund.
Younger-investor remuneration
The first noteworthy result is that a brand-name 2040 target-date fund may anticipate to pay an expense ratio of approximately 0.32 percentage point each year on average. However, investors may build the identical fund (using the same fund family mutual-fund products) for less than 0.18 percentage point each year. Over a ten-year period, this equates to a 2.5-percentage-point return premium.
The second noteworthy result is that the savings are much higher for longer-dated retirement funds—for younger individuals who will not retire for decades.
It Pays to Do It Yourself
Excess returns obtained by ‘doing it yourself’ rather than purchasing a target-date fund.
Over a ten-year period, excess returns
Target-date fund expense ratio
The expense ratio for a matched “do it yourself” fund.
Excess returns over a ten-year period by retirement-year goal
2020
2025
2030
2035
2040
2045
2050
2055
2060
An cost ratio of 0.34 percentage point each year is expected for investors purchasing a brand-name 2060 target-date fund. They could accomplish it for an average of 0.17 percentage point a year if they built the identical underlying fund (using the same fund-family offerings). Over a ten-year period, this equates to a return increase of more than three percentage points.
One reason contributing to this benefit for younger investors is that as a fund’s retirement date approaches, the fund management is substituting large-cap stock, foreign stock, and small-cap stock funds with short-duration debt, inflation-protected bond funds, and high-dividend-paying equities. The investor saves a few hundredths of a percentage point in cost ratios due to this differential in holdings. The second reason is that when a fund’s retirement date approaches, the fund family begins to charge more for it—possibly because younger investors are less price-sensitive when it comes to investing.
One bright spot
On the plus side, 10% of the target-date funds in our sample were offered “at cost,” meaning that the expense ratio of the target-date retirement fund equaled the weighted average of the underlying components. Attempting to duplicate these target-date funds would not save an investor any money.
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On the other hand, more than 10% of target-date funds had an expense ratio higher than the DIY portfolio by more than 0.60 percentage point each year. The result: Almost a 10-year period, investors who replicated the target-date fund would earn over 10% more in returns.
Overall, intrepid and attentive investors (particularly younger investors) should consider the cost reductions associated with starting their own fund. The temptation to timing markets and rebalance too often is, of course, a drawback of doing it yourself. A do-it-yourself portfolio, on the other hand, may earn you a few percentage points in retirement if you can resist that temptation.
Dr. Horstmeyer is a finance professor at George Mason University in Fairfax, Virginia. Reports@wsj.com is his email address.
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The best target date mutual funds are a type of mutual fund that has an objective to match the investor’s desired retirement date. Investors should create their own target date.
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