MONEY funds

3 Bad Reasons We Pay So Much For Mutual Funds

Why do investors let active managers reel in their assets? Getty Images

The numbers say that cheap index funds are your best bet. So why are people still willing to pay fund managers so much?

Every time the market makes a big turn, this happens: A bunch of money managers previously hailed as brilliant get caught betting the wrong way. This time it’s hedge fund managers making “macro” bets. For example, the $13 billion fund run by Paul Tudor Jones is down 4.4%, according to the Wall Street Journal, while the general stock market is up 5.4% and bonds are up 3.4%.

Meanwhile, in the prosaic world of mutual funds available to you and me, the evidence is overwhelming that most managers can’t beat the market. Over the past five years, according to S&P Dow Jones Indices, about 73% of blue chip stock funds trailed the S&P 500 index. You can buy a passive S&P 500-tracking index fund for almost nothing—as little as 0.05% of asset per year—and get roughly all of the market’s return. Funds that instead use human being to pick stocks often charge 1% to 1.4%, for worse results.

In a post on his Pragmatic Capitalist blog, Cullen Roche wonders why people keep buying these funds that cost more and deliver less. His explanations sound right—you should read them—and boil down to people being poorly informed and too emotional about investing. Not everyone knows how hard it is to beat the market, and the ones who do are overconfident about their ability to do better.

But I’d like to propose a few more reasons people like active funds, which go beyond overoptimism. I’m not advocating for these active approaches. In each case, if this why you use active funds, I’ll suggest an alternative way of coming at the problem.

1) Using an active fund as a de facto financial adviser.

Many if not most fund managers these days are “closet indexers,” meaning they stick pretty close to a stock benchmark like the S&P 500, with just a few deviations they hope will goose performance enough to justify their fees. But there is a subset of managers with a broader mandate. They mix up U.S. stocks, foreign stocks, bonds and other assets. Some, like the popular T. Rowe Price and Fidelity “target-date” funds, shift among these assets according to a pre-set formula based on their investors planned age of retirement. Others move around based on their views about whether, say, U.S. stocks look expensive or cheap. But in either case, their investors may not really be coming to them for market-beating stock picks. They are using those funds to help find the right split among stocks and bonds.

In other words, these funds are stand-ins for the financial advisers who help people set up their portfolios. The advice isn’t personal, but really good personal advice is hard to get if you don’t already have a big portfolio.

The better alternative: Buy a target date fund that uses cheap index funds instead. Or an index-based “balanced fund” with about 60% in stocks and 40% in bonds. Even if that’s not quite the optimal mix, the advantage of low fees is often more important. Or you can build your own cheap three fund portfolio using the index funds on the Money 50 recommended list.

If what you really want is a fund manager who knows when to get you out of stocks before they drop, well, the truth is neither fund managers nor advisers are likely to time these turns consistently well. Investors who want to preserve capital in bear markets are better off just dialing back their stock exposure as a matter of policy.

2) Going active to get a tilt.

Not everyone wants exactly the level of risk the stock market delivers. Investors willing to live with more volatility to get a higher return might, for example, want to add more small companies to their portfolio. Likewise, there is some evidence that a bias toward value stocks can deliver better returns over the long run. For a long time, buying an active mutual fund was really the simplest way for most people to get a slightly different mix of risk and return characteristics than the market offered.

Those days are over. You can buy an index-based exchange-traded fund to capture almost any slice of the market or stylistic tilt. I’m skeptical of whether most of these funds are worth the bother, but many are cheaper and more reliable than pure active funds.

3) That enterprising feeling.

I’ve been a convinced indexer for so long that sometimes I forget how cynical the approach can sound to the uninitiated. You’re just tossing your money into the market and betting that on average it works out. Mutual fund managers, on the other hand, say they are scouring companies’ “fundamentals,”and “kicking the tires,” and “thinking of ourselves as owners of businesses.” (Never mind that for many fund managers holding a stock for a year is what counts as a long-run strategy.) At first blush, this doesn’t only sound like a smart way to make money… it sounds like the right thing to do. A way to be a good steward of wealth and to help build the American economy. I’m often struck by how people seem to admire Warren Buffett not only as a smart businessman with a rare stock picking ability, but as a kind of spirit guide. Not for nothing is his annual shareholder meeting called the Woodstock of Capitalism.

Roche has what I think is a deep insight that might make you think differently about this. The money you put into equities via your 401(k) or IRA isn’t really “investing,” just saving with more risk and an incrementally better expected return than bonds. That’s because you aren’t handing any funding to the company, but buying an old claim on it from someone else.

…the reality is that when you buy stocks or bonds on a secondary market you are allocating your savings into what was really someone else’s “investment” and it’s very likely that the easy money has already been made and these real “investors” are cashing out. Real investors build future production, make great products, provide superior services and only sell their majority interest in that production at a much later date (often on a stock exchange via an IPO).

Whether you buy an active fund or an index fund, you’ll be at a pretty distant remove from the companies you indirectly own. On average, you won’t have much chance of a big return, and some tire kicking here and there won’t add a lot of value. There’s nothing wrong with that. Most of us don’t have the time or the interest to be even part-time entrepreneurs. There’s no shame—and a lot of gain to be had—in keeping it cheap and simple and moving on.

MONEY Social Security

Surprise! Even Wealthy Retirees Live On Social Security and Pensions

Older Americans with six-figure portfolios rely on old-fashioned programs for half their income.

Where do affluent retirees get their income? Portfolios invested in stocks and bonds, you might think—but you’d be wrong. Turns out many are living mainly on Social Security and good old pensions.

That’s the surprising finding of new research from a surprising source: Vanguard, a leading provider of retirement saving products like individual retirement accounts and 401(k)s. Vanguard studied the income sources and wealth holdings of more than 2,600 older households (ages 60-79) with at least $100,000 in retirement savings. The respondents’ median income was $69,500, with median financial assets of $395,000. (The value of housing was excluded.)

The researchers were looking for answers to a mysterious question about the behavior of wealthier retirement account owners: Why do few of them draw down their savings? They found that nearly half the aggregate wealth of these households comes from the two mothers of all guaranteed income programs, Social Security (28%) and traditional defined-benefit pensions (20%).

The median annual income for these households is $22,000 from Social Security, with an additional $20,000 from pensions. Tax-deferred retirement accounts came in third among those who have them, at $13,000 (11%).

“Only a small number of the people who have 401(k)s and IRAs are really relying on them as a regular source of income,” said Steve Utkus, director of the Vanguard Center for Retirement Research. “There’s a lot more income from pensions than we expected,” he adds.

That last finding may seem surprising, given all the publicity about shrinkage of defined-benefit pensions. Although most state and local government workers still have pensions, only a third of private-sector workers hold a traditional pension, down from 88% in 1975, according to the National Institute on Retirement Security. And NIRS data points to a continued slide in the years ahead.

“Will this look different 10 years from now—will we have less pension income and more from retirement savings accounts? I think so,” Utkus says.

Another interesting finding: 29% of affluent retirees get some income from work, with a median income of $24,600. And the rate of labor force participation was even higher—40%— among households more reliant on retirement accounts.

“That’s only going to jump dramatically over the next few years,” Utkus says. “All the surveys show there’s a real demand for work as a structure to life. People say they can use the money, or they want to work to get social interaction.”

The findings are all the more striking because the big buzz in the retirement industry these days is about how to generate income from nest eggs. That includes creation of income-oriented portfolios, systematic drawdown plans and annuity products that act as do-it-yourself pensions.

Yet few retirement account holders actually are tapping them for income. The Investment Company Institute reports that just 3.5% of all participants in 401(k) plans took withdrawals in 2013. That figure includes current workers as well as retirees; the numbers are higher when IRAs are included, since those accounts include many rollovers from workplace plans by retired workers. With that wider lens, 20% of younger retired households (ages 60-69) take withdrawals, according to a study for the National Bureau of Economic Research and the Social Security Administration’s Retirement Research Consortium.

The income annuity market has been especially slow to take off. One option is an immediate annuity, where you make a single payment at the point of retirement or later to an insurance company and start getting a monthly check; the other is a deferred annuity, which lets you pay premiums over time entitling them to future regular income in retirement.

Deferred annuity sales doubled in 2013, to about $2 billion, according to LIMRA, the insurance industry research and consulting group. But that’s still a drop in the bucket of the broader retirement products market. And the Vanguard survey found that just 5% of investors surveyed held annuity contracts.

“The theme of translating retirement balances into income streams is emerging very slowly,” Utkus says.

The Vanguard study also underscores the importance of smart Social Security claiming decisions, especially delayed filing. “There’s been a sea change over the past year,” Utkus says, with more people recognizing that delayed filing is one of the best ways to boost guaranteed income in retirement. Vanguard is “actively discussing” adding Social Security advice to the services it offers investors, he says.



MONEY 401(k)s

Working for a Small Business? Your 401(k) Is Probably Small, Too.

At Mom-and-Pop companies, workers may miss out on perks like employer matches. Here's what to do.

You might call it retirement inequality. Over the past couple of decades, 401(k)s have become our national retirement plan, but you are most likely to be offered one if you work for a large- and mid-sized company. Only 24% of small businesses offer a 401(k).

If you’re working at small business that provides a 401(k), congrats—you can make headway in retirement saving. Many small business 401(k)s are doing a decent job, a new Vanguard survey found. The survey covered 1,418 of the fund group’s small business 401(k)s, those with up to $20 million in assets. The average plan had 44 participants and held $2.4 million.

But your savings are likely to lag your counterparts at larger employers. Compared with overall 401(k) balances, small plan accounts are just half the size—an average $55,657 in 2013 vs. $101,650 for 401(k)s overall. Still, small balances rose 10% gain over $50,610 in 2012. Median balances, which better reflect the typical employee, averaged just $11,171, up just 2% from $10,950 in 2012.

One reason for the difference: Small businesses tend to offer lower salaries than large companies, and many have higher turnover, so workers have less time to save. Company matches may also be less generous. Three out of four small businesses offer an employer contribution, compared with 91% of 401(k)s overall, according to Vanguard. Some 44% provided a matching contribution, 10% offered both a match and non-matching contribution, and 21% gave out a non-matching contribution only.

In other ways, small business plans are keeping up with larger 401(k)s. Participation averaged 73%, similar to overall levels. The savings rates were lowest for employees younger than 25—only 46% contributed in 2013. And just 47% of those earning less than $30,000 saved in their plans. For those who did join, the typical savings rate was 7.1% of pay, nearly identical to the overall savings rate.

Mirroring larger plans, the most popular investment was a target-date fund, which gives you an all-in-one asset mix that shifts to become more conservative as you near retirement. Two-third of small business workers had all or part of their portfolio in a target date fund, while 46% held one as their only investment. Another 6% opted for a balanced fund or other model portfolio.

The one 401(k) feature not explored in Vanguard’s small business survey: costs. Of course, Vanguard is famous for its inexpensive fund and ETF offerings. But outside of Vanguard’s orbit, many 401(k)s are saddled with with high fees—and that’s especially true for small plans, which lack economies of scale.

If you’re investing in a small business 401(k) plan, save at least enough to get a full match, if one is offered. And choose low-cost, broad index funds, if they’re available. If your plan charges a lot—more than 1.25%—put any additional money in a Traditional or Roth IRA. Aim to save as much as 15% of pay, both inside and outside your plan. That way, your nest egg will grow bigger, even if the business remains small.


MONEY stocks

How Owning Apple Stock is Now Like Owning Bonds

Inside Apple's balance sheet is a whole lot of cash and bonds. Jesus Jauregui—Getty Images

Apple's stock split makes it easier to buy. But you'll get a big bond fund as part of the bargain.

By splitting its shares 7-for-1 today, Apple has made its stock more easily accessible to retail investors. But of course if you have any money at all in an equity mutual fund, you almost certainly own a chunk of Apple APPLE INC. AAPL -1.5583% . The stock is 3.11% of the S&P 500 S&P 500 INDEX SPX -1.3249% , making it the biggest name in the index.

What you get if you own Apple is, of course, a world-beating consumer technology company. But you also get a huge chunk of cash and bonds—about $150 billion worth, or 27% of Apple’s total market value. One way to wrap your head around how much extra money Apple is managing is to compare it to the biggest bond mutual funds in the country. If Apple’s fixed-income portfolio were a fund, its only real peers would be the giant Pimco and Vanguard portfolios, the mainstay core holdings in many 401(k) plans.

Source: Morningstar, Apple
Source: Morningstar, Apple

If you’ve ever scratched your head and wondered why investors complain about Apple’s cash, as if being wildly successful at pulling in profits is a bad thing, this is why. If you have money to put in the market and wanted some of it to go into bonds, you could hand that money over to Pimco and Vanguard and get a reliable return. No one needs Apple CEO Tim Cook to be a bond manager.

Cook knows that, which is why Apple has announced it plans to return $130 billion in cash to shareholder via dividends and stock buybacks by the end of 2015. Of course, even if it does that, it would still have loads of cash on hand—the company generated about $36 billion in cash flow from operations in the six months ended March 31. That alone is enough to do twelve more Beats-sized deals. (One odd wrinkle: To get cash back to shareholders, Apple is actually borrowing. It’s a tax thing.)

Bottom line: If you buy Apple today, between now and the end of next year, you’ll get a lot of that money back and will have to figure out somewhere else to invest. Another portion will earn modest returns. And then you hope the rest is invested back in the business or in smart acquisitions in a way that continues to power growth forward. Shawn Tully over at thinks Apple is just too big to deliver the kind of growth Apple fans hope for. Then again, if you subtract Apple’s “bond fund” from its market value, you get the part of the business that’s still a tech company for about 11 times the past year’s earnings, compared to just under 20 for the S&P 500. Assuming you think Cook won’t waste the cash, that doesn’t sound like such a terrible deal.

MONEY 401(k)s

Vanguard Study Finds (Mostly) Good News: 401(k) Balances Hit Record Highs

Stock market gains boosted wealth for those putting away money regularly in the right funds. Are you one of them?

If you’ve been stashing away money in a 401(k) retirement plan, you probably feel a bit richer right now.

The average 401(k) balance climbed 18% in 2013 to $101,650, a new record, according to a report by Vanguard, which is scheduled to be released tomorrow. That’s an increase of 80% over the past five years.

The median 401(k) balance — which may better reflect the typical worker — is far lower, just $31,396. (Looking at the median, the middle value in a group of numbers, minimizes the statistical impact of a few high-income, long-term savers who can skew the averages.) Still, median balances rose 13% last year, and over five years, they’re also up by 80%. All of which suggests that rank-and-file employees are building bigger nest eggs.

Vanguard balances
Source: Vanguard Group

That’s the good news. Now for the downside. Those rising 401(k) balances are mostly the result of the impressive gains that stocks have chalked up during the bull market, now in its sixth year. (The typical saver currently holds 71% in stocks vs. 66% in 2012.) Why is that a negative? Because at some point stocks will enter negative territory again, and all those 401(k) balances will suffer a setback.

Meanwhile, the amount that workers are actually contributing to their plans remains stuck at an average of 7% of pay, which is down slightly from the peak of 7.3% in 2007. And nearly one of four workers didn’t contribute at all, which has been a persistent trend.

Ironically, the savings decline is largely a side-effect of automatic enrollment, which puts workers in 401(k)s unless they specifically opt out. More than half of all 401(k) savers were brought in through auto-enrollment in 2013. These plans usually start workers at a low savings rates, often 3% or less. Unless the plan automatically increases their contributions over time—and many don’t—workers tend to stick with that initial savings rate.

Still, when you include the employer match—typically another 3% of pay—a total of 10% of compensation is going into the average worker’s plan, says Jean Young, senior research analyst at Vanguard. That’s not bad. But most people need to save even more—as much as 15% of pay to ensure a comfortable retirement, according to many financial advisers. (To see how much you should be putting away, try the retirement savings calculator at AARP.)

Even if 401(k) providers haven’t managed to get people to step up their savings rate, they are tackling the problem of investing right. More workers are being enrolled in, or opting for, target-date retirement funds, which give you an all-in-one asset allocation and gradually shift to become more conservative as you near retirement. Some 55% of Vanguard savers hold target-date funds—and for 30%, a target fund is their only investment.

With target-date funds, as well as managed accounts (which are run by investment advisers) and online tools, more 401(k) savers are also receiving financial guidance, which may improve their returns. As a recent study by Financial Engines and AonHewitt found, 401(k) savers who used their plan’s investing advice between 2006 and 2012 earned median annual returns that were three percentage points higher than those with do-it-yourself allocations.

Vanguard’s data found smaller differences. Still, over the five years ending in 2013, target-date funds led with median annual returns of 15.3% vs just 14% for do-it-yourselfers.

The lessons for investors: You’re better off choosing your own 401(k) savings rate, and try to put away more than 10% of pay. And if you aren’t ready to manage your own fund portfolio, opting for a target-date fund can be a wise move.








MONEY Warren Buffett

One Weird Trick That Will Help You Beat the Market Like Warren

Warren Buffett Ben Baker—Redux

Here's a no-brainer way to win with "Warren" stocks. It won't do you any good now, but it would have been brilliant in 1993.

My story, Inside Buffett’s Brain, is about the search by financial economists and money managers for persistent patterns in stock returns. Some of these patterns might help to explain why a handful of money managers, including Buffett, have done so well. The story is about more than Buffett, though. The hunt through past market data for potentially winning strategies is a big business, and has fueled the growth of exchange-traded funds (ETFs). So a word of warning is in order.

Here’s the result of astoundingly simple Buffett-cloning strategy I put together, inspired by a “modest proposal” from Vanguard’s Joel Dickson. All you have to do buy stocks with tickers beginning with the letters in “Warren.” (You have double up on the “r” stocks, natch.)

Winning with Warren NEW

This likely “works” in part because it’s an equal-weight index—meaning each stock in the W.A.R.R.E.N. portfolio is held in the same proportion. Traditional indexes like the S&P 500 are “capitalization weighted,” meaning they give more weight to the biggest companies in the market. Because smaller stocks have outperformed in recent years, equally weighted indexes have done pretty well compared to traditional indexes in the period in question.

So you might find out that you can also beat the market with an equally weighted basket of stocks whose tickers begin with the letters in your name too. Just cross your fingers and hope the trend doesn’t reverse in favor of blue chips.

Another reason why this trick worked is that it picks from among current S&P 500 names, which means the stocks on the list are already in a sense known winners. Companies that used to be small and then graduated to the S&P 500 are on list, and companies that used to be big and then got small or disappeared aren’t on the list. But you couldn’t know which companies those were in 1993.

This is obviously dopey, and no way to run your money. (And the ideas I wrote about are much, much more sophisticated than this.) But there’s a serious point here. ETFs are a great way to buy cheap, reliable exposure to the stock market. But these days most ETFs track not a simple well-known benchmark, but a custom index built upon rules which, if followed, are thought to give investors an edge. For example there are indexes which tilt toward companies with better-than-average sales, or which specialize in certain sectors or investment themes.

These indexes often have really impressive past performance. In theory. Based on “back tests” of market data, from before the index was actually in operation.

And of course they do. Today indexes are often created with an ETF launch in mind. So there’s not much point in building an index and marketing it if you don’t know that the strategy has already won. Unfortunately, knowing what’s already worked in the past doesn’t mean you know what will work in the future.

In fact, investors in new indexes are likely to be disappointed. Samuel Lee, an ETF strategist at Morningstar, explains that in any group of past winning strategies, a high number will have won just through sheer luck. The future average performance of those strategies is almost certain to decay. Because luck runs out.


Mutual Funds Gone Down the Drain

Forty-one percent of U.S. mutual funds operating 10 years ago, closed before 2014.

Your mutual fund does worse when its close to extinction. Here's what to do about it.

Of all traditional U.S. mutual funds operating a decade ago, four in 10 shut down before 2014, reports Morningstar.

Why care? Even though you can cash out (or get shares in a fund absorbing the loser), costs rise and performance falls as the end nears, says Daniel Kern, president of investing firm Advisor Partners, who has studied closures.

Here’s how not to get swept away in the failures.

Stopping your losses

Seek high marks. Eight in 10 funds given five stars by Morningstar in 2002 lived to 2012; only 39% of one-star funds did, according to a study Kern co-wrote. Stewardship grades, gauging how shareholders are treated, count too: A and B funds outlast low-ranked ones, says Morningstar’s Laura Lutton.

Don’t think small. Bigger funds aren’t always better, but those that stay small or shrink too much have high failure rates. Be wary of portfolios with assets well under $250 million, says Kern’s collaborator Tim McCarthy, author of The Safe Investor.

Exit early. If you think a fund will close, sell. Funds lose an average of 3.6% in their final 18 months, Vanguard has found. Has your fund already merged into another offering? Be picky, advises San Diego planner Leonard Wright, and sell the new one if you wouldn’t have bought it otherwise.

MONEY 401(k)s

How to Get Low-Cost Index Funds into Your 401(k)

Index funds are hard to find in some 401(k)s, but you needn't let high fees sink your retirement. Illustration: Paul Blow

Index funds are hard to find in some plans, but you needn't let high fees sink your retirement.

After more than 30 years, the 401(k) has become our de facto national retirement savings plan. So how is it that most participants can’t build a portfolio out of the best, cheapest investments around — index funds?

In 2013 this should not be an issue. Decades of studies have shown that funds that simply track market benchmarks outperform actively managed funds over the long run because of the huge difference in fees — a typical 401(k) stock index fund may charge 0.06% of assets, vs. 0.63% for the average fund run by a manager who picks equities.

Assuming a 7% annualized return before expenses over 25 years, that fee difference can mean a 9% bigger nest egg.

The unhappy status quo exists in part because regulators are loath to demand that specific investments be included in 401(k) plans. And in designing plans, employers rely on consultants and fund groups, which have an incentive to favor higher-cost offerings.

Today most 401(k)s offer a single index option that usually invests in large stocks like those in the S&P 500. Only 42% of plans with indexing include an intermediate bond fund, and just 31% have a foreign-stock fund, according to consultants Aon Hewitt.

Even at index king Vanguard, “only about four out of 10 plans we manage offer enough index funds to build a core portfolio,” says Steve Utkus, head of Vanguard’s center for retirement research.

What can you do if your plan lacks index funds? Start by lobbying your employer — new rules require 401(k)s to disclose fees, which may nudge your boss in the right direction. Meanwhile, here are three coping strategies:

Check out your plan’s target date fund. Even if you lack enough standalone index options, your target-date fund, a mix of portfolios designed to grow conservative as you near retirement, may have them.

Vanguard’s index target series has been pulling in the most cash, $20 billion in 2012, according to Morningstar. Now Fidelity, Wells Fargo, and BlackRock have all-index offerings that provide enough diversification for you to be able to use them as your core holding.

Opt for low-cost active funds. Otherwise, make the best of your options. Look for the cheapest fund in each market segment you want to invest in.

“Owning more actively managed funds within an asset class means you’re more likely to lag your benchmark,” says Portfolio Solutions adviser Rick Ferri, who has studied the benefits of indexing over active portfolios.

Index outside your 401(k). If you’re stuck with high-cost stock funds charging near 2%, or bond funds charging half that, invest enough to get your employer’s match. Then fund a Roth IRA or taxable account, buying stock index funds that generate little in capital gains. You’ll end up with a larger nest egg, a goal your employer should want to share.


Balance Out a Lopsided Index Fund

Critics point out that stock index funds have a knack for loading up on frothy investments at the worst possible times. Photo: Kevin Van Aelst

How much of your portfolio should be invested in index funds has long been a weighty question. Or rather, a question of weights.

An index fund, of course, buys and holds all the stocks listed on an index, like the S&P 500 — but it’s not quite that simple. Most indexes are weighted by capitalization so that they hold more of whatever the market assigns the most value to. That makes them, in part, a popularity contest.

Critics have long pointed out that stock index funds have a knack for loading up on frothy investments at the worst possible times. Now a related critique is coming from a source who is hard to dismiss.

Vanguard founder Jack Bogle, who started the first retail index mutual fund, has recently been critical of bond market indexes. Again, it comes down to weighting. He says indexes have forced so-called total bond market funds to hold too much U.S. Treasury and government-related debt just when those securities are yielding next to nothing.

The fact that Bogle is questioning the suitability of an index investment that millions of investors use prompts the question, Is it time for you to rethink indexing?

MONEY has long been an advocate of low-cost index funds. After reexamining the case for passive investing and looking especially hard at its weak points, three guiding principles emerged:

No. 1: With U.S. stocks, indexing is very, very tough to beat.

Despite weighting issues, indexing starts with two huge advantages. The first is that investing is a zero-sum game of sorts. The investors who manage to outsmart the market have to be matched by other investors who got outsmarted. Over time, in this highly competitive game, it is very hard to identify fund managers who will be consistent winners.

The second is that index funds keep costs extremely low — you can buy a traditional cap-weighted index exchange-traded fund for under 0.1% a year, vs. more than 1% for the average actively managed domestic stock fund.

Most managers can’t beat the market by enough to surpass their fee. Over the past three years, just 14% of large-cap funds pulled it off.

Action plan: Use total stock market index funds for your core holdings in equities. You can cover the broad spectrum of domestic and foreign stocks with just two funds: Schwab Total Stock Market Index SCHWAB CAPITAL TST MK INDEX SELCT SWTSX -1.3348% (expense ratio: 0.09%) and Vanguard FTSE All-World ex-U.S. ETF VANGUARD INTL EQUI FTSE ALL-WORLD EX-US ETF VEU -1.2591% ( 0.15%).

Related: Money 50: Best Mutual Funds and ETFs

You can even add stakes in more targeted index funds that help you meet specific needs.

For example, if you’re older and seeking income, you may tilt toward dividend-paying stocks by adding to your core Vanguard Value ETF VANGUARD INDEX FDS VANGUARD VALUE ETF VTV -1.2931% (0.10%), which holds lower-priced stocks with an average yield of 2.5%.

“Pick your own asset-allocation strategy, and then you can use index funds to implement it,” says New York City financial planner Lew Altfest.

No. 2: Index funds can still get into bubble trouble.

“What a traditional cap-weighted index represents is the market’s equilibrium — the prices buyers and sellers have agreed on for every security in the market,” says Joel Dickson, a senior strategist with Vanguard. Yet the market sometimes collectively gets things wrong. Think back to the tech bubble in the late 1990s, when that sector grew to be more than a third of the entire U.S. stock market as a result of the mania in Internet stocks.

Today, a worry has arisen about emerging-markets index funds, which recently held nearly half of their assets in companies based in the so-called BRIC economies — Brazil, Russia, India, and China. There’s no telling whether the market’s current judgment will seem wise in hindsight. But it’s fair to say that a broad emerging-markets index concentrates risk in a narrow group of countries.

Action plan: Avoiding lopsided exposure is straightforward on the international side. Advisers recommend spreading your bets beyond just the BRICs into other markets, such as Indonesia and Mexico.

To do that, keep your current investment in a broad emerging-markets fund. With new money, though, add a fund that weights differently, such as iShares MSCI Emerging Markets Minimum Volatility ISHARES INC MSCI EMRG MKTS MIN VOLA ETF EEMV -1.1204% (0.25%) with a third less in the BRICs than the standard emerging-markets index.

How to avoid bubble exposure in U.S. indexes is less settled. Some index critics have designed their own alternative “fundamental” indexes, which are supposed to correct the tendency to load up on hot stocks.

For example, PowerShares FTSE RAFI U.S. 1000 POWERSHARES EXCHAN FTSE RAFI US 1000 PORTFOLIO PRF -1.3535% (0.39%) weights not by a company’s stock market value, but by dividends, sales, and other indicators of business strength. Rob Arnott of Research Affiliates, which oversees the RAFI index, says his benchmark “has a pronounced value tilt” — that is, to stocks that are relatively unloved.

In theory, this should mute the effects of momentum-driven bubbles. Yet fundamental funds ran into their own problems in 2008 — they were loaded up on financial stocks heading into the crisis. They are also more expensive than their traditional counterparts.

You can almost as easily tilt away from go-go stocks by adding an indexer restricted to value, such as the Vanguard Value ETF VANGUARD INDEX FDS VANGUARD VALUE ETF VTV -1.2931% , or small companies, like Vanguard Small Cap ETF VANGUARD INDEX FDS VANGUARD SMALL-CAP ETF VB -1.392% (0.10%). (Bubbly stocks don’t stay small for long.)

No. 3: Handle bond indexes with care.

Indexing fixed income has never been as simple as it is with equities. For starters, “you’ve got the ‘bums’ problem,” says Paul Kaplan, director of research at Morningstar Canada and an indexing expert.

With stocks, capitalization weighting means loading up on the market’s biggest winners. With bonds, this approach calls for betting big on the market’s biggest debtors. Global bond index funds end up overweighting government bonds from Japan and Western Europe.

Here at home, U.S. Treasuries and government-related debt now make up more than 70% of the Barclays U.S. Aggregate bond index, with corporates representing less than 25%. Bogle thinks the Barclays aggregate bond index is flawed because it reflects not only bond purchases of investors but also those of foreign governments like China that are buying Treasuries more for policy purposes, not just because they think Treasuries are a great investment.

He argues that once you strip away government and central bank purchases of Treasury debt, government securities probably make up about a third of the U.S. debt market.

Action plan: A simple solution is to take half of your stake in a total bond market index fund and use that to buy a corporate bond index fund, such as Vanguard Intermediate-Term Corporate Bond Index VANGUARD SCOTTSDAL VANGUARD INTER-TERM CORP BD VCIT 0.6442% (0.12%). The combination of the two will give you a portfolio that’s about two-thirds corporates and one-third governments. Alternatively, consider an active fund with a long track record of spotting bond values, such as Loomis Sayles Bond LOOMIS SAYLES FD I BOND FUND RETAIL CLS LSBRX -0.0649% ( 0.92%).

Overseas, it’s a tougher challenge. There are few index funds that give you exposure to the broad array of governments and corporates in both the developed market and the emerging world.

As a result, you’re better off anchoring your overseas bond holdings with an actively managed fund like MONEY 50 recommendation Templeton Global TEMPLETON INCOME T GLOBAL BOND FUND CLASS'A' TPINX -0.2261% ( 0.89%), whose top weightings are in low-debt nations like Poland, Mexico, South Korea, and Ukraine. Compare that with the Barclays Global non-U.S. Treasury index, whose top holdings are from Japan, with a sky-high debt-to-GDP level of about 212%. Talk about lopsided.


Building Your Own Target-Date Fund

I’m 30 years old and recently rolled my savings from a 401(k) into an IRA. I had been investing in a target-date retirement fund. But now that I have virtually unlimited investment options, I’m wondering whether I should just create the same portfolio using individual funds or ETFs. What do you think? — Brandon L., Rochester, N.Y.

Essentially, you’re asking whether you’re better off building your own target-date retirement fund or buying one off the shelf.

While you might be able to lower your expenses and thus boost your return with the DIY approach, it depends on how much you have to invest, which funds or ETFs you choose and how much work you’re willing to put into building and managing your own target-date portfolio.

To illustrate, let’s take a look at the Vanguard target-date fund designed for someone your age, the Vanguard Target Retirement 2045 VANGUARD CHESTER TARGET RETIREMENT 2045 FD VTIVX -1.1284% .

This fund invests 90% of shareholders’ money in stocks and 10% in bonds by divvying up its assets among three Vanguard index funds as follows: total stock market index (63% of assets), total international stock index (27%) and total bond index (10%). To invest in this fund, you pay annual expenses of 0.19% of assets, or $19 per $10,000 invested.

You could create a virtually identical portfolio by just investing your money in a total stock market index, a total international stock index and a total bond market index fund in the same proportion a target fund holds them. But you wouldn’t necessarily save any money by doing so.

Related: What is an index fund?

Why? Because if you prorate the expenses to reflect the percentage that each fund would represent in your portfolio — 63% of the total stock market index’s 0.18% annual expenses, 27% of international stock fund’s 0.22% cost and 10% of total bond market’s 0.22% expense ratio — you end up with pretty much the same 0.19% in total expenses. (I say “pretty much” because the total bond market fund in the target date fund isn’t available to individual investors and has slightly different expenses than the one that is.)

But there are a few ways you may be able to pay less.

One is to invest in the same three underlying index funds, but buy a different share class of those funds.

When Vanguard assembles its target portfolios, it uses “Investor” shares. Vanguard has a cheaper version — called “Admiral” shares –but doesn’t use them in its target portfolios. You, however, can build your own target fund with the cheaper Admiral shares.

There’s one, rub, though: Each of the Admiral shares requires a $10,000 minimum initial investment, as opposed to a mere $1,000 minimum for the target-date fund.

As a practical matter, that would mean you would have to create a portfolio with at least $100,000 in assets in order to meet the $10,000 minimum for the bond index fund, while at the same time assuring that the bond fund represents no more than 10% of your portfolio overall.

If you can clear that hurdle, duplicating the 2045 target fund with Admiral shares would reduce your annual expenses by almost half from 0.19% to 0.10%. But while that represents a nearly 50% reduction in expenses, in dollar terms we’re not talking about a huge difference: about $90 a year for every $100,000 invested. Whoopee!

The second way you might be able to do better is by building the equivalent of a target fund portfolio with ETFs, which many firms, including Vanguard, allow you to buy without paying trading commissions.

Vanguard requires only a $3,000 minimum investment to open a brokerage account and invest in ETFs, so by going with ETFs you can get around the $10,000 minimum for Admiral shares.

And since Vanguard’s fees on the Admiral share and ETF versions of its total stock market, international stock index and total bond index funds are identical, you could reap the same savings in annual expenses as with the Admiral shares. (Vanguard’s brokerage firm levies a $20 annual fee for accounts with balances under $50,000, but you can sidestep that by agreeing to electronic delivery of confirmations and statements.)

There’s one other move you could try: Going with the funds or ETFs of another firm, such as Fidelity or Schwab, both of which have been chipping away at the fees on their index funds and/or ETFs.

For example, Schwab now charges just 0.04% for its version of a total stock market index ETF and 0.05% for its total bond market index ETF. Schwab doesn’t offer the equivalent of a total international stock index ETF that includes small-caps and emerging markets, but you could cobble one together by combining a few separate international Schwab ETFs.

I estimate that by mixing and matching various Schwab ETFs, you could create something close to the Vanguard target-date fund for roughly 0.06% in annual expenses. That’s about 40% lower than the 0.10% or so that you would pay with Vanguard ETFs.

Again, though, the dollar savings won’t exactly blow you away.

Even on a $100,000 investment, the difference would be about $130 a year vs. the Vanguard 2045 target fund and $40 compared to a DIY target portfolio made up of Vanguard Admiral funds or ETFs. In fact, the savings could be even smaller, as ETFs have other potential costs such as the bid-ask spread and the extent to which the ETF sells at a discount or premium to net asset value.

Which brings us to the larger question: Does it really makes sense to go to the trouble of creating your own target-date portfolio?

The idea behind these funds is simplicity and ease.

A target fund gives you a diversified portfolio of stocks and bonds appropriate for your age and shifts more of its assets to bonds as you age so your savings are less vulnerable to stock-market shocks as you near and enter retirement. They’re not perfect, but target funds can provide a reasonable investing strategy that many investors may not be able to come up with or stick to on their own.

If you build your own target portfolio, you have to set your asset allocation and maintain a “glide path,” or gradually move out of stocks and into bonds.

Even if you mimic a target-date fund for someone your age, you’ve still got to do the work. That will include periodically selling shares to rebalance the mix between domestic stocks, international shares and bonds. If the funds are held outside a tax-advantaged account, such sales could mean paying tax on realized gains.

Bottom line: If you’re investing a large sum and willing to monitor and fine tune your homemade target fund, then I suppose the potential savings you can reap might be worth it. But for the overwhelming majority of investors considering a target-date fund, I think buying a target fund off-the-rack is a more realistic approach.

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