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VFORX: How A Target Date Fund Should Be Built

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.

Peer Inside The iShares S&P 500 Value ETF

Summary The individual holdings look fairly solid with a heavy exposure to XOM. The sector allocations are going heavy on the financial sector. While those financial firms may benefit from raising short term rates, I’d rather hedge rate risk and add more exposure to utilities. The iShares S&P 500 Value ETF (NYSEARCA: IVE ) is one way to get the value exposure for your portfolio. On the other hand, if you prefer to look at individual sectors you may find the holdings a little more concerning as 25% of the equity is invested in the financial sector. Generally I have tendency to prefer the value side of the index, but going so overweight on financials is an interesting aspect of the fund. Quick Facts The expense ratio is .18%. I have a strong preference for very low expense ratios, so this is a bit higher than I like to see. With over $8 billion in assets under management, it seems better economies of scale could be achieved, but the higher expense ratio may simply reflect more profits to the sponsor of the fund. Holdings I put together the following chart to demonstrate the weight of the top 10 holdings: (click to enlarge) I love seeing Exxon Mobil (NYSE: XOM ) as a top holding. Investors may be concerned about cheap gas being here to stay, but I think money in politics will be around decades (centuries?) longer than cheap gas. Bet against big oil at your own peril. I find the exposure to AT&T (NYSE: T ) interesting simply because the 2.4% weighting is almost twice that of Verizon (NYSE: VZ ). I find the telecommunications sector a little risky because of the intense price based competition brought by Sprint (NYSE: S ). The sector will probably find a solution to the intense competition, but I’ve gotten burned pretty badly by the mining sector where industry competition reached absurd levels and companies opted to focus on lowering their own costs by increasing production and driving down prices. Declining prices for the product combined with increased production and intense capital expenditures is a pretty ugly situation. Outside the Top 10 Outside of the top 10 you’ll find Johnson & Johnson (NYSE: JNJ ) as 1.64% of the portfolio. This is another great dividend company to hold. They have an effective R&D team and a global market presence. Just look at their dividend history and try to come up with a reason that this company shouldn’t be in a dividend growth portfolio: (click to enlarge) Beyond JNJ you’ll also see other dividend champions like Wal-Mart (NYSE: WMT ) and Pepsi (NYSE: PEP ). The heavy exposure to dividend champions is one reason for investors to appreciate the value side of the index. Wal-Mart has been on a massive slide lately but I don’t see it getting much worse before it gets better. The market for equity can be a little too short sighted in valuations. While Wal-Mart is seeing their already thin operating margins get pressed even thinner amid higher wages, they are also the low cost leader. When Wal-Mart raises prices, the rest of the industry should follow. Who will undercut Wal-Mart? Will it be Target (NYSE: TGT )? I doubt Target really wants to do that since they raised wages also and have the same challenge. Sectors Going heavy on financials hasn’t been my style, but increasing interest rates may benefit them more than the rest of the economy. It’ll be interesting to see how much higher the Federal Reserve can push interest rates without crashing the economy. What to Add The biggest weakness here in my opinion is the relatively small position in utilities. Since utilities often have a material correlation with bonds, I’d like to see a little more utility exposure in the portfolio. An investor could modify the exposure by simply adding the Vanguard Utilities ETF (NYSEARCA: VPU ) to their portfolio when using IVE as a substantial holding. Conclusion The expense ratio is a bit high and the concentration in the financial sector is a little higher than I’d like to see. However, the rest of the portfolio exhibits some great traits with a focus on established dividend growth champions that have the size and experience to whether difficult market environments. All things considered, I think there is more to like than to dislike in this portfolio. Some investors with a very long holding period may want to look for options with slightly lower expense ratios. If investors have a shorter time frame or intend to move their positions more frequently the healthy liquidity on IVE should be attractive for creating a smaller bid-ask spread.

LQD: This Huge Bond Fund Looks Very Solid

Summary LQD offers investors exposure primarily to the 3 to 10 year portion of the bond market with 27% going to the very long portion of the yield curve. Allocations to the very long end of the yield curve (over 20 years) combine with investment grade credit quality to create negative correlation with the S&P 500. The expense ratio is a little higher than I like to see, but it isn’t too bad. Compared to a large bid-ask spread on other bond ETFs, total ownership cost should be attractive. It appears the fund has free trading through TD Ameritrade and Fidelity. The iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ) is a huge bond ETF. The ETF has around $24 billion in assets under management. While the additional size may not be a substantial factor for shareholders, the average trading volume over 900,000 shares translates into around $10 million per day. For investors that want to be able to move in and out of the bond market, high liquidity is a huge advantage since it reduces the bid-ask spread. Expenses The expense ratio for LQD is.15%. This isn’t the best expense ratio an investor can find, but isn’t too high either. The real question here is how long an investor would plan to hold the fund. If the holding period is several years then there is an advantage to going for a rock bottom expense ratio. Some of the smaller bond ETFs have demonstrated bid-ask spreads greater than 1%. That can be a real pain. Crossing that bid-ask spread once would be equivalent to the expense ratio for 7 years. Add in that investors are only going to save a few basis points and there are some material advantages from the better liquidity of LQD. Yield The yield is 3.46%. It isn’t very high, but as you’ll see when we go through the portfolio this is investment grade corporate debt with only moderate duration exposure. Duration The following chart demonstrates the sector exposure for this bond fund: This is a fairly nice collection. The fund is pretty much excluding short duration bonds that have fairly weak interest rates in favor of holding those along the middle of the yield curve. To boost yields there is also a material allocation to the very long duration securities. Sectors The following chart demonstrates the sector exposure for this bond fund: I don’t see a huge problem here. The fund avoids having a huge exposure to the energy sector which is beneficial since the falling prices could trigger downgrades for several of the smaller companies in the sector. Since the fund is holding investment grade debt and has an enormous amount of assets, having to sell off bonds from a smaller issuer after a downgrade could push the price of those bonds down due to illiquidity of the underlying bonds. The allocation list goes on to include several incredibly tiny sector allocations. If you wish to see the full list, it is available on the fund’s website . Credit The next major issue to look at is the credit rating of the companies in the fund. The debt is investment grade, but the fund is walking the line in that regard to generate higher yields. As long as the management is watching the underlying liquidity, I don’t see a problem. Notice that there is a very little investment in AAA rated debt. This fund intends to take on some credit risk to enhance returns, but it doesn’t intend to take on much. For the investor seeking stronger yields than treasuries can provide without the credit risk of junk bond funds, this is a fairly reasonable compromise. By focusing on investment grade debt and incorporating some longer maturities the fund retains a negative correlation with the S&P 500. Over the last 2 years that correlation was -.15. For the investor that likes to rebalance their holdings occasionally and values negative correlation for the market the liquidity here really shines. Conclusion Overall this is a fairly solid bond fund. The duration risk is not overwhelming, but it is enough to generate negative correlation to the broader stock market. For any shorter term bond investments, the liquidity here trumps the difference in expense ratios. I did a quick search on brokerages with free trading on the ETF since an investor planning to rebalance or adjust their position frequently would want to avoid commissions. It appears TD Ameritrade and Fidelity are offering commission free trading on LQD. I’m giving this bond fund a 9.5/10 rating. If the expense ratio dipped under .10%, it would be a very solid 10.