Last week at the annual Bogleheads conference, we had the opportunity to visit the Vanguard headquarters and have a Q & A session with several Vanguard experts. A few people asked questions about Vanguard’s Target Retirement funds. Most of those questions were answered by John Ameriks (the head of Vanguard’s Investment Counseling and Research Group), who from what I understand played a key role in designing the Target Retirement funds.
I had a few followup questions, which Ameriks was kind enough to answer for Oblivious Investor readers. (Thanks to Linda Wolohan of Vanguard’s PR team for putting me in touch with Ameriks, by the way!)
Piper: During the panel discussion, you mentioned that the funds are rebalanced back to their target allocation daily using cash flows into or out of the fund, but that if cash flows were not sufficient to get the fund back to its target, further rebalancing would only occur if the fund’s allocation had strayed outside of a certain tolerance range. How far “out of whack” could a Target Retirement fund’s asset allocation get before the fund’s policies mandate that the fund manager execute further rebalancing transactions?
Ameriks: Because it could potentially allow someone to estimate what type of cash flow would need to come in or out of specific funds within a very narrow point in time, I don’t think it’s prudent to get into more specific detail. And secondly, while we do have a rigorously defined quantitative dashboard that is used in managing the rebalancing process, ultimately, (as with all funds) transactions are subject to the decisions of the portfolio management team, who have the responsibility of ensuring, to the best of their ability on a day-to-day basis, that the fund is managed in a manner that is consistent with the funds’ stated goals and objectives.
Piper: Presumably part of the purpose for using the tolerance ranges (rather than automatically rebalancing all the way back to the target allocation every single day) is to reduce turnover costs, correct?
Ameriks: The purpose behind the rebalancing activities is to keep the fund’s asset allocation and risk levels in line with the glide path. It’s important to do that in as continuous a fashion as we can. In a theoretical model in which there are no transaction costs, it’s a completely continuous process. But given that there are costs, what we’ve tried to do is come up with an approach that balances the various costs involved with maintaining risk control against the value that we think maintaining risk control brings.
Piper: Do the LifeStrategy Funds basically follow the same approach with regard to rebalancing?
Ameriks: They do. The funds of funds all follow a similar set of policies and procedures around rebalancing.
Piper: I hear from a lot of investors who like the idea of a hands-off portfolio — such as that offered by the Target Retirement or LifeStrategy Funds — but because of circumstances or preferences, they want to customize the allocation in some way — to include tax-exempt bonds instead of the Total Bond Market fund, for instance. I understand that the point of the Target Retirement Funds is to cater to as broad of an audience as possible.
Ameriks: That’s correct. The best fit for the most people.
Piper: But are there any thoughts as far as potentially building out the fund-of-fund lineup at all to include other allocations?
Ameriks: It’s a question that we’re always asking: is there another category or another variation that we think there’s sufficient demand and a sufficient rationale for putting together?
On the Target Retirement funds, we do sometimes get questions about whether risk-rated target date funds are something we’d think about doing. [Mike's note: That is, conservative, moderate, and aggressive versions for each of the funds.] We think about it, for sure. I think the big issue that we have trouble getting around is that the target date structure is really intended to try to make it as easy as it can be. And it’s still hard. I’m completely on-board with the notion that people still do need to think about their asset allocations, and they need to take into consideration their circumstances. But still you want to make the decision-making process easy.
And in particular in a 401(k) plan, you want to make it as easy as it can be for a plan sponsor to choose the default. And it gets very tough — once you introduce risk rating, you put the onus back on the plan participant to think about, “am I conservative, am I aggressive, or am I moderate?” And you make the decision architecture complex again.
The other thing we know is that when you offer a broad population of 401(k) investors conservative, moderate, and aggressive options, the overwhelming tendency is for people to choose the middle option anyway. [When you add risk-rated target funds] you’re introducing complications and making it harder for people to enter the plan, which you absolutely don’t want to do, and you’re not moving the dial very much.
Last but not least, I very much view target date funds and other balanced fund options as completely amenable and useful as a core portion of a portfolio in a situation in which someone articulates a good reason for it not to be their total portfolio. Customizing around it by adding one piece to the portfolio can make a lot of sense.
Piper: Is there a particular reason that there is no Admiral share option for the funds of funds?
Ameriks: It’s not as much of a no-brainer as it might seem. Operationally it would be difficult to create share classes of the funds of funds.
And then you would face the issue of how do you deal with the minimums in such a structure? We have Admiral shares on the basis that the holder of the Admiral fund has at least a certain amount of dollars in the fund. For some of the target date funds, we have bond allocations of just 10%. So if 10% of the fund is in Total Bond, and there’s a $10,000 requirement to get Admiral [for the Total Bond fund], are we talking about setting a $100,000 minimum to get Admiral treatment for those funds-of-funds?
The ongoing issue we’re trying to balance here is to find a pricing structure where we are providing the services that we provide, at cost, for people. And it’s a balancing act.
So is the question of being able to provide lower prices for target date funds and funds-of-funds on our minds? It absolutely is.
Piper: Are there any specific plans for changing any of the underlying Target Retirement allocations in the future?
Ameriks: In terms of changes to target date, it’s important to say that we do expect these portfolios to evolve over time. We are going to continue to do research. We are looking at these things on an ongoing basis and doing formal updates of our analysis around the glide path. We look at it a lot. But that doesn’t mean we’re going to change it.
We tend to look at it through a lot of lenses. For example, we’ll do some historical analysis and look at it that way, and see if we’re in an acceptable range. We’ll look at shareholder behavior and see if things are acceptable from that standpoint. When a preponderance of indicators suggest that a change would make the funds a better solution for the investors that are using them, then we’re going to take steps to make those changes.
So at this point, there are no specific plans to make changes to the target date funds. But I would make sure that everyone understands that it is not something that we set and forget. We’re constantly looking for ways to either improve diversification or reduce costs or provide a better fit for the shareholders. So people should expect some evolution over time.
What will not change is the philosophy: that it should be easy for every investor to understand what’s going on in those funds.
[Mike's note: This discussion was edited for brevity's sake.]