How Investors Can Win With Target Retirement Funds
July 18, 2019

How Investors Can Win With Target Retirement Funds

Investing in the stock market is like a long bicycle race. Sometimes, the markets give us tough hills to climb. Other times, they provide huge tailwinds. Over the past ten years, most investors hitched onto giant sails. U.S. stocks have risen in 10 out of the past 11 calendar years.

That’s unusual. And if Morningstar’s annual Mind the Gap study is any indication, investors behaved well during this rising market. They didn’t frantically sell or trade when the market looked scary because, well… it didn’t look scary. U.S. stocks had a record-tying nine-year run. * The S&P 500 rose in 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016 and 2017. This might have given investors courage to stick to the funds they owned.

In contrast, when investors have doubts, they often trade. This causes most investors to underperform the funds they buy. For example, a fund might earn a 10 percent annual return over a given time period. But if investors trade in and out over that same time period, the average investor might earn 8 percent per year. This is “the gap” that Morningstar refers to in its Mind The Gap reports. Fear, greed and speculation cost investors money. That’s why during a period that includes both bull and bear markets, investors often underperform their funds by 2 percent per year or more.

But that wasn’t the case over the past 10 years, with the solid rising market. According to Morningstar, over the decade ending March 2018, the typical dollar-weighted return for U.S. stock market funds was 8.9 percent per year after fees. In contrast, the typical dollar-weighted return for investors in those same funds was 8.3 percent per year. That means investors underperformed their funds by just 0.60 percent annually.

Over time, however, markets rise and fall. So if we want a better indication of how investors behave, we need a longer measuring stick. A 15-year period would be a much better test. After all, the 15-years from June 30, 2004 to June 30, 2019 included rising and falling markets.

U.S. and international stocks rose a lot between 2005 and 2007. Then they both fell hard in 2008. Stocks recovered some of that ground in 2009. But global markets soon wobbled. Stocks plummeted in 2008 so many people expected the same thing when markets fell midway through 2010.

Investors, it appears, didn’t behave well.

Morningstar’s Mind The Gap series doesn’t extend back to 2004, but the fund rating company did run a cash-flow analysis on several funds over the past 15 years. By doing so, they’ve been able to estimate how investors performed compared to the funds they owned. Over this 15-year period (which included a market crash) most investors underperformed their funds. They might have second-guessed what they owned. When a particular fund performed poorly (see the European index below) they might have jumped out, only to jump back in after the fund had a better year. As you can see below, this cost investors plenty.

How Did Investors Perform Compared To The Funds They Owned?
June 30, 2004 – June 30, 2019

Fund Fund’s Average Annual Performance Investors’ Average Annual Performance Annually, How Much Did Investors Underperform or Outperform Their Funds?
Vanguard’s S&P 500 (VFINX) 8.62% 6.34% -2.28%*
Vanguard’s Total Stock Market Index (VTSMX) 8.88% 9.33% +0.45%*
Vanguard’s Extended Market Index (VEXMX) 9.33% 8.65% -0.68%
Vanguard’s International Stock Market Index (VGTSX) 5.67% 4.47% -1.20%
Vanguard European Stock Market Index (VEURX) 5.52% 0.93% -4.59%
Vanguard Pacific Stock Market Index (VPACX) 5.05% 0.34% -4.71%
Vanguard’s Total Bond Market Index (VBMFX) 4.12% 3.61% -0.51%

However, investors in Target Date funds fared much better. These are diversified portfolios rolled into single funds. Fund companies rebalance them for investors. For example, Vanguard’s Target Retirement 2045 fund averaged a compound annual return of 7.38 percent over the 15-year period ending June 30, 2019. But investors in the fund averaged a compound annual return of 8.07 percent. In other words, most of this fund’s investors performed better than the fund itself.

Here’s how investors can outperform their funds during volatile market conditions: Many continue to add the same amount of money every month. As a result, they buy a greater number of units when the markets fall. They buy fewer units (with the same amount of money) when the markets rise. And when they’re committed to a single, diversified fund, investors are less likely to jump around. That’s how an investor could pay a lower-than-average unit price for a fund over time…and beat the fund’s return.

Best of all, this doesn’t require any thinking.

Below, I’ve listed all of Vanguard’s Target Retirement funds that have 15-year track records. I’ve also shown how each fund performed compared to how its investors performed in each respective fund.

Investors In All-In-One Funds Appear To Behave Better
June 30, 2004 – June 30, 2019

Fund Fund’s Average Annual Performance Investors’ Average Annual Performance Annually, How Much Did Investors Underperform or Outperform Their Funds?
Vanguard Target Retirement 2015 Fund 5.95% 5.63% -0.22%*
Vanguard Target Retirement 2025 Fund 6.53% 6.73% +0.20%
Vanguard Target Retirement 2035 Fund 7.02% 7.53% +0.51%
Vanguard Target Retirement 2045 Fund 7.38% 8.07% +0.69%

Investors in all-in-one products don’t always outperform their funds. But they appear to behave better than those who buy individual funds. In February 2018, Morningstar’s Jeffrey Ptak published, Success Story: Target Date Fund Investors. He wrote:

To gauge investors’ success, we estimated the difference between target-date [all-in-one] funds’ dollar-weighted and time-weighted returns for the March 1994 to January 2018 period…the annual behavior gap was a modest negative 0.38 percent, which is smaller than the gaps we’ve observed in other asset classes in the past.”

Target Date funds are a popular choice in employer-sponsored retirement plans. That’s one reason their investors behave so well. Such plans invest employee contributions each and every month. You might not have access to an employee-sponsored plan. But there’s much to learn from this. Target Date funds can remove decision-making. And during normal market conditions (when markets rise and fall) Target Date investors don’t have to fight the enemy in the mirror.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.