Reader’s response

Last month’s column, “When indexing isn’t an improvement,” pointed out that Vanguard Target Retirement 2030 (VTHRX), which only owns index funds, had tracked two of its five biggest actively managed rivals during the 10-year period ended Aug.31. This struck me as noteworthy, given that the CFA Institute Research Foundation had recently suggested that the 401 (k) plan sponsors consider only holding index funds, both for investment reasons and for reduce their fiduciary responsibility.

Several readers responded by email, writing that Vanguard’s fund had not led the way as it was positioned more conservatively. Their thesis was that Vanguard’s fund had been hampered during the long bull market because it held a lower stock position than its rivals. However, over a full market cycle, Vanguard 2030 would triumph, thanks to its ongoing cost advantage.

A valid point. If it was correct, it would have weakened my point. Fortunately for my pride, I had anticipated this concern in advance and had checked the equity weightings of each fund at the start and end of the 10 year period to make sure the comparison was fair for the Vanguard funds. It was. Each time, Vanguard 2030’s equity weighting came in the middle of the six-fund pack.

Equity weighting

Which begs the question: what To determined the relative performance of funds? Today’s article provides the answer, at least partially.

I started the assessment by adjusting the calculation period to span the 10 calendar years from 2011 to 2020. (Using the calendar years, I ensured that the necessary data would be available.)

Hmmm. Vanguard’s fund held the third highest weighting in equities during the period 2011-2020, and it finished with the third highest returns. Would the correlation be so direct? Do the 10-year performance of the six funds correspond directly to their share percentages?

I extracted the net equity position of each fund, at the start of the 10 calendar years, from Morningstar Direct. (Morningstar.com provides such information for five years but not for 10.) I then compared the rank order of the average stock rating of the six funds to the rank order of their total returns.

Sorting funds by their equity weighting revealed most of the story of relative performance. JPMorgan SmartRetirement 2030 (JSMIX) was the only fund to maintain its exact position, ranking last on both accounts (sometimes caution doesn’t pay off), but no fund except Principal LifeTime 2030 (PMTIX) shifted by more than one slot. Principal’s fund fell two ranks, from the third weight in equities to the fifth in terms of returns. In the grand scheme of things, however, even this move was modest.

Extend Analysis

Yet relying on the single data point of equity holdings might overstate the virtue of parsimony. After all, the decade has been marked by a huge divergence between the performance of domestic and foreign stocks: the Morningstar US Market Index has appreciated by 13.9% per year, while the Morningstar Global Index ex US has risen by 13.9% per year. won that 5.5%. Domestic stocks easily beat all other portfolio investments, but not so much foreign stocks. It was also useful to have bonds rather than cash.

So I improved the study. It looked at each fund’s exposure to four asset classes: 1) domestic stocks, 2) foreign stocks, 3) bonds and 4) other. Since there were now four categories instead of one, I couldn’t just rank the output. Instead, I calculated the “projected returns” for the calendar year by multiplying the percentage of assets that a fund has at the start of each year in an asset class by the total returns for that class. For example, this is the projected return for American Funds Target Date Retirement 2030 (REETX) for the year 2011.

(Note: The Others category is mostly foreign bonds and cash. Therefore, I modeled it by averaging the performance of the Morningstar Global ex US Core Bond Index and the Morningstar US Cash T Index. -Bill.)

The real return of the fund was negative 1.86%. This projection was closer than most (you didn’t think I would choose the wrong example, did you?), But none of the estimates came very far from the truth. I then combined the 10 calendar year projections to arrive at an annualized projected return for each fund. Once again, I placed the funds in order. I then compared the ranking order of the projected returns to the orders from sorting funds by: 1) their equity exposures; 2) their expense ratios, from lowest to highest; and 3) their actual total returns.

I admit that the table is confusing, but I can quickly get straight to the point. To my surprise, calculating the four categories did not improve the forecast of stock weights. In fact, the calculation of the four categories performed slightly less well, as it pushed the entry of US funds lower in the scale and Principal’s fund higher. Both movements were in the wrong direction. However, both methods of sorting funds based on their portfolio holdings were found to be superior to ranking funds based on their expense ratios. This correlation was essentially zero.

Wrap

Do not generalize the preceding sentence! This column assessed funds that have multiple moving elements, during a bull market that has reduced the importance of spending differences, with actively managed funds that are all industry leaders. In addition, none of the active funds have particularly high expense ratios. So this was not a typical comparison between cheap index funds and expensive active funds. In such circumstances, index funds are very likely to prevail.

No, I think so. The performance of target date 2030 funds – as well as target date funds in other vintages – will be largely determined by their equity weighting.

John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar generally agrees with the opinions of the Rekenthaler Report, his opinions are his.