In one of my recent Finance Friday posts, I talked a bit about re-balancing your portfolio. I wanted to bring it back up again to talk about how I’m saving some money by using a DIY Target Date Fund. Doing this I’m able to save over $1,000 per hour of effort. And only with a frequency of once or twice a year.
Target Date Funds
First off, you might be wondering what a Target Date Fund (TDF) is. A TDF is a (usually) small collection of assets that change over time based on some predefined future date. In other words, as an investor’s needs change as they age this fund should change with them. TDFs are generally named in increments of 5~ years of future year dates. Often times you could see these within some of the available funds in your employer sponsored 401k! The Vanguard 2060 Target Date Fund that I used to be invested in is one of many.
The idea is that the Vanguard fund has a 2060 target date which is 41~ years into the future. As such, the funds will begin with a much higher ratio of stocks rather than bonds. While stocks are a riskier/more volatile asset, there is a long time horizon until the target date hits. This will often be the best opportunity for your money to grow in value.
This Schwab fund with a target date of 2025 looks a bit different with a focus on more bonds than stocks. Similar to the above reasoning, since the time until the target date is a LOT sooner, the bond allocation has increased to reflect this. Stocks still dominate the fund, but much less so than something with a longer time horizon.
Finally, let’s look at a fund which has a target date of something that’s already been passed. In the Fidelity 2015 Target Date (FFVFX) you’ll begin to see a majority of bond/cash allocations. Conservation and stability is valued more heavily once you’ve reached your target date. Preserving your capital at this point is the main goal as opposed to growth.
Why Target Date Funds Are Used
One advantage to using a TDF in the first place is the inherent diversification. Having a diversified portfolio is key to minimizing your risk while investing in the market. TDFs span across 3-10 different funds on average and the average fund can hold hundreds of different assets. This allows us to lower the variance in our portfolio. If one company goes into the gutter, it won’t affect us as much if they’re only a small portion of our holdings. Essentially, we all want to make more money with as little stress as possible!
The key reason why the average investor might use a TDF is because of the “Set it and Forget it” nature of them. If you want, you could just set up an automatic transfer from your paycheck to your brokerage. From there you would set it up to sweep any standing cash into the fund. This is an extremely simple way to pay yourself first and get really good value out of your money. It’s SO easy to just throw all of your cash into one fund and leave it there until you need it. As simple as a savings account, but with much more growth potential!
Why would you create your own Target Date Fund?
As in all things, learning how to do something yourself is extremely valuable. Whether it be cooking for yourself, building your own furniture, or fixing up things in your house, there’s tons of savings to be had. In this case as well, we can quantify how valuable being able to do this really can be. TDFs, as with all professionally managed funds, are subject to what are called expense ratios. An expense ratio is a fee you pay in the form of giving away a small percentage of that investment’s gains throughout the year. Expense ratios can range from 0% to monstrous like 9.41%. Many TDFs have higher expense ratios than the combination of the underlying assets. Mostly because there is effort required in managing the changing asset allocations.
Take a look at the tables below to get an idea of what I mean. The Actual Expense Ratio is the expense ratio that the brokerage offers for that specific fund. The Calculated Expense Ratio is the expense ratio you would incur if you purchased the same funds on your own at the same allocation percentage. The Fund Weight
Vanguard is the only one which shows a very similar ratio between the actual and calculated, but we’re missing a crucial point. Most of Vanguard’s index funds have two different “versions” – Investor Shares or Admiral Shares. The two types of shares are more or less exactly the same except Admiral Shares can cut the expense ratio even lower than they already are. This is because the Admiral Shares generally require a non-0 minimum investment to be eligible. All of the funds in the Vanguard 2060 TDF are using their corresponding Investor shares version instead of the Admiral Shares. Theoretically you could create the Vanguard 2060 fund for a significant expense ratio cut just by using the matching Admiral Share versions of each underlying fund.
Really Doesn’t Seem Like Much
“But When I’m Retired, this seems like a lot of work, is it really worth it?”
I hear you. 0.04% doesn’t seem like a lot to be concerned for, but consider this: This is an Annual occurrence and your portfolio SHOULD be increasing every year. This means that as your portfolio grows it’s going to cost you a bit more as well every year.
I used this calculator from Nerd Wallet to find out just how much it would cost to pick a more expensive fund.
I’m going to use a modest initial investment of $10,000 in our fake investor’s brokerage account and make the following assumptions:
- Our investor contributes an additional 15k to his/her account each year
- They have a time horizon of 40 years – they just started working pretty recently
- Our investor will expect an annual Rate of Return of ~7.7% – The average performance of the S&P over the last 90 years
Take a look at the cost of using the TDFs from each brokerage over those 40 years:
By cutting your expense ratio now, you could be saving some insane amounts of money. The best part is, it’s not even an exorbitant amount of work either. I would say if you’re just starting out, this could take 3-4 hours and then you would be done with it for the year. In future years, once you’ve gotten into a rhythm, you could easily cut this down to a 1-2 hour session.
If this took you 80 hours (2 weeks worth, while still having weekends!) over the course of 40 years, you would theoretically have an insane hourly wage. If you use the DIY Fidelity fund, you’re making $6,500 per hour of work. That’s more than 99% of people could even dream of. If that’s not worth the effort, I don’t know what is.
Alright, How Can I Make my Own Target Date Fund?
1. Figure out your desired Asset Allocation.
You want to know what spread of assets you’ll be investing in so that you can pick the correct funds to buy. One way to do this is to check out a target date fund for a date that makes sense for you. For me, it was the 2060 Vanguard TDF since I was initially planning to retire around 65. The normal retirement age. From here you can just take the asset allocation straight from the TDF you chose. Use that as your baseline and adjust as necessary for your goals.
2.Select your brokerage.
There are a host of brokerages these days which sport index funds which you can purchase without paying any commission. My suggestions are places like Vanguard, Charles Schwab, and Fidelity. Often times these funds are restricted to their own site as well. You can’t buy VTSAX, a Vanguard fund, on Charles Schwab. In reality, many of the funds are pretty similar so I would pick the brokerage which you think has the better user experience.
3. Select your investments.
The fun part! Here’s where you get to start investing. By now, you should have an idea of what kind of assets you want to buy based on your asset allocation. You could very simply buy the exact same assets shown in the TDF with the exact same proportions, or you could adjust it a bit as you see fit.
The beauty of the DIY fund is that it can change with YOUR needs, not what someone else thinks is best for the average X-Year Old.
Maybe you need to be more conservative in some years due to saving for a house. Maybe you want to go for broke and go all in with stocks for a few years because you want the maximum growth opportunities. The TDFs you’re looking at are merely a guideline for you to keep the advantages of the TDF. A fund which re-balances over time to correspond with your age.
4. Re-balance every year or so.
This is a very minimal amount of work. With Vanguard, it’s even easier because of the ability to “Exchange” funds for one another with ease. It’s essentially a sell and buy in one transaction. Here you’ll just be taking a look at your funds and seeing if the value of your assets are still aligned with your chosen asset allocation. Hint: They likely won’t be! Check out my post here to learn a bit about your options for re-balancing!
5. Repeat 1-3 every 5 years or so.
Again, the point of the target date fund is to ensure you’re keeping your investments in line with your goals. These goals can change over time and you should take the opportunity to adjust your plan as things change. If you’re younger you could probably get away with setting and forgetting for even longer, but I would still recommend some self reflection regardless. It’s always a good idea to check yourself.
Target Date Funds are a great tool for the lazy investor. They’re simple, easy, and extremely useful. However, expense ratios can turn into some nasty hidden fees if you aren’t careful. DIY-ing takes all the perks of Target Date Funds and exchanges an extremely limited amount of added work with a potential boat load of money. If you currently invest in one I recommend taking a look at your fund and trying to do a similar analysis that I did to see how much you could be saving down the line.