A research study on 401(K) participation by Barry Schwartz, who wrote the book Paradox of Choice: Why Less is More, concluded that when there were too many fund choices, people deferred their investment decision and they never ended up making decision at all. When they were given fewer mutual funds to choose from, people responded very well and they ended up signing up to participate in the 401(K) plan. This may be one reason why your company sponsored 401(K) plan has fewer choices than you would typically find with IRA Accounts or Individual Accounts.
Mutual Fund companies like Vanguard or Fidelity have recognized this problem. Therefore, they created what is known as "fund of funds" , "all in one funds", "asset allocation funds" or "target retirement date funds" to simplify investment decisions for investors.
A fund of funds is nothing but a mutual fund that invests in other mutual funds. Just as a mutual fund invests in a number of different securities, a fund of funds holds shares of many different mutual funds.
Fund of funds provide greater diversification than traditional mutual funds because you are purchasing multiple underlying funds when you buy a single fund of funds. So, it is a great way to diversify your investments with just thousand dollars. Another way to think of fund of funds as a broadly diversified portfolio wrapped in one fund. On the downside, expense fees on fund of funds are typically slightly higher than those on regular funds because they include part of the expense fees charged by the underlying funds.
If you are a young investor or someone just starting out with small amount of money, I highly recommend fund of funds. Once you get used to investing and love tweaking your asset allocation to maximize your returns, then only I would recommend investing in individual mutual or index funds.
I personally own 3 target retirement date funds in my portfolio. My 401(K) investment, which is just about a third of my total investments, is completely in the Vanguard Target Retirement Date 2050 fund. Additionally, I own Vanguard Target Retirement Date 2030 fund that I am using as a college fund for my kids. Lastly, I own Vanguard Target Retirement Date 2060 fund that I am using as a fund to hold mortgage payoff money. I am planning to payoff my mortgage in 2 years. So, instead of holding the money in CDs or money market funds, I decided to invest in an aggressive target date fund so money grows quickly within 2 years.
Vanguard offers goal based LifeStrategy Funds or retirement date based Target Retirement Date Funds. LifeStrategy funds provide fixed allocation to underlying index funds depending on the goal. The Target Retirement Date funds provide variable allocation depending on the retirement date. As your retirement date nears, the funds become more conservative in their asset allocation.
The LifeStrategy Income Fund is the most conservative and seeks to provide current income and some capital appreciation and holds 20% stocks and 80% bonds. The LifeStrategy Conservative Growth Fund seeks to provide current income and low to moderate capital appreciation holds 40% stocks and 60% bonds. The LifeStrategy Moderate Growth Fund seeks to provide capital appreciation and a low to moderate level of current income and holds 60% stocks and 40% bonds. The Growth Fund seeks to provide capital appreciation and some current income and holds 80% stocks and 20% bonds.
Vanguard offers 12 different Target Retirement Date Funds depending on one's current age or target date of retirement. The most aggressive fund The Target Retirement Date 2060 fund invests in 90% stocks and 10% in bonds. The most conservative fund invests in 65% bonds, 30% in stocks, and 5% in short-term reserves.
Fidelity also offers fund of funds. The Fidelity Freedom Funds are their Target Retirement Date funds. Fidelity Asset Allocation funds allow you to choose an asset allocation based on your own risk tolerance. The underlying funds in case of Fidelity are their actively managed funds.
Fidelity offers only one fund of index fund. Fidelity Four-in-One Index Fund includes Spartan 500 Index Fund, Spartan Extended Market Index Fund, Spartan International Index Fund, Spartan U.S. Bond Index Fund.
Conclusion
If you are just starting out or have very little money to invest, then look no further than a fund of funds. It will greatly simplify your investment decisions and your investments will be broadly diversified right from the start. Between Fidelity and Vanguard, Vanguard wins the battle for superior choices for fund of funds. Fidelity Freedom Funds include too many of their actively managed funds. Their performance had lagged recently behind their benchmarks and peers. However, Fidelity Four-in-One Index Fund is an excellent choice as it is simple, and more importantly, it is based on underlying index funds.
[...] If your life is extremely busy, and you love simplicity, then simply invest in a Target Retirement Date fund. Target Retirement Date funds are broadly diversified because they are made of up of multiple funds. These funds gradually become more conservative as your year of retirement approaches and reduce risk automatically. Depending on your target retirement date, find a suitable fund and start investing in it. More on fund of funds investing. [...]
ReplyDeleteFairly new to investing but learning quickly. Do you have any thoughts on using one of these funds as a base and further investing to customize the portfolio? I'm currently in the Vanguard 2050 Fund but thinking that I'd like a portfolio with the same type of glide path but less of an amplitude change (less aggressive now then not dropping as quickly toward the target date). I know I'd have to pay particular care to not duplicate stocks, but in theory I like the concept.
ReplyDeleteJust wanted to know if there were any thoughts on a strategy like this. Thanks.
Justin,
ReplyDeleteThanks for the comments. I like the idea and that is what I do for my own portfolio. Individually owning the underlying funds gives you finer control over asset allocation. Also, you save on expense ratio because my understanding is that Vanguard charges expense ratio for Target Date fund that is on top of the expense ratio for the underlying funds. So, why pay extra for the convenience when you can do the same thing through disciplined investing?
Also, on the glide path and amplitude question, the key is simply to get started. As the time goes by, you can easily tweak allocation by diverting more or less money in the funds. For me I used to worry about this too, but I have learned that when you automate your investing, you worry less and less. I don't pay much attention these days.
Target Date funds are a good choice for people who don't want to spend time or don't want the hassle or who don't have any clue on investing. Also, these funds are great for companies for automatic signing up new employees to participate in 401(K) plan.
You may want to see the details of my portfolio (% allocation is outdated now).
http://www.buyandholdblog.com/my-investment-portfolio-details/
http://www.buyandholdblog.com/my-investment-portfolio-details-part-2/
With that said, I do own a couple of Target Date Funds -- one in my 401(k) and other fund as college education fund for my children. I've explained reasons in the above two articles. I hope this helps.