Do I need to own all the funds my target-date funds owns to mimic it?

Question

I just calculated out that investing my Roth IRA in a Lifecycle fund will cost me about $65k more than investing directly in the underlying funds, effectively doubling the expense ratio. And the funds they choose aren't exactly low expense either!

I'm considering implementing my own retirement investing strategy based on this approach, but one of many questions I have is: do I really need all these funds? There's like 9 funds the fund allocates less than 2 percent to, and I expect the glide path to shrink those over time. I understand there's some benefits to diversification, but I don't see how allocating 1 percent to "small cap growth" can offset losses from an "all sector" investment ten times its size.

Answer 1

If you read Joel Greenblatt's The Little Book That Beats the Market, he says:

Owning two stocks eliminates 46% of the non market risk of owning just one stock. This risk is reduced by 72% with 4 stocks, by 81% with 8 stocks, by 93% with 16 stocks, by 96% with 32 stocks, and by 99% with 500 stocks.

Conclusion:

After purchasing 6-8 stocks, benefits of adding stocks to decrease risk are small. Overall market risk won't be eliminated merely by adding more stocks.

And that's just specific stocks. So you're very right that allocating a 1% share to a specific type of fund is not going to offset your other funds by much.

You are correct that you can emulate the lifecycle fund by simply buying all the underlying funds, but there are two caveats:

1. Generally, these funds are supposed to be cheaper than buying the separate funds individually. Check over your math and make sure everything is in order. Call the fund manager and tell him about your findings and see what they have to say.

2. If you are going to emulate the lifecycle fund, be sure to stay on top of rebalancing. One advantage of buying the actual fund is that the portfolio distributions are managed for you, so if you're going to buy separate ETFs, make sure you're rebalancing.

As for whether you need all those funds, my answer is a definite no. Consider Mark Cuban's blog post Wall Street's new lie to Main Street - Asset Allocation. Although there are some highly questionable points in the article, one portion is indisputably clear:

Let me translate this all for you. “I want you to invest 5pct in cash and the rest in 10 different funds about which you know absolutely nothing. I want you to make this investment knowing that even if there were 128 hours in a day and you had a year long vacation, you could not possibly begin to understand all of these products. In fact, I don’t understand them either, but because I know it sounds good and everyone is making the same kind of recommendations, we all can pretend we are smart and going to make a lot of money. Until we don’t"

Standard theory says that you want to invest in low-cost funds (like those provided by Vanguard), and you want to have enough variety to protect against risk. Although I can't give a specific allocation recommendation because I don't know your personal circumstances, you should ideally have some in US Equities, US Fixed Income, International Equities, Commodities, of varying sizes to have adequate diversification "as defined by theory." You can either do your own research to establish a distribution, or speak to an investment advisor to get help on what your target allocation should be.

Answer 2

The goal of the single-fund with a retirement date is that they do the rebalancing for you. They have some set of magic ratios (specific to each fund) that go something like this:

Years to Retirement | Asset Mix
       40           | 90% stocks, 10% bonds
       30           | 80% stocks, 20% bonds
       20           | 70% stocks, 30% bonds
       10           | 50% stocks, 50% bonds
        0           | 30% stocks, 70% bonds

Note: I completely made up those numbers and asset mix.

When you invest in the "Mutual-Fund Super Account 2025 fund" you get the benefit that in 2015 (10 years until retirement) they automatically change your asset mix and when you hit 2025, they do it again. You can replace the functionality by being on top of your rebalancing.

That being said, I don't think you need to exactly match the fund choices they provide, just research asset allocation strategies and remember to adjust them as you get closer to retirement.

Answer 3

Over time, fees are a killer. The $65k is a lot of money, of course, but I'd like to know the fees involved. Are you doubling from 1 to 2%? if so, I'd rethink this. Diversification adds value, I agree, but 2%/yr? A very low cost S&P fund will be about .10%, others may go a bit higher. There's little magic in creating the target allocation, no two companies are going to be exactly the same, just in the general ballpark. I'd encourage you to get an idea of what makes sense, and go DIY. I agree 2% slices of some sectors don't add much, don't get carried away with this.