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Portfolio > Portfolio Construction

Vanguard Study Boosts TDFs, Plugs Financial Advisors

By Gil Weinreich

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A recently released Vanguard study goes some distance to rehabilitate the image of target-date funds, all-in-one portfolios with an age-based allocation between stocks and bonds that are often seen as lacking in sophistication.

The study, by Vanguard’s Stephen Weber, is based impressively on an analysis of more than 58,000 Vanguard IRA account holders and reinforces classic themes of responsible investing—such as the value of sticking with an investment plan rather than succumbing to the temptation to trade.

But the study’s greatest significance may lie in its last two lines (occurring long after the conclusion has been stated): namely, that having a financial advisor may be the critical element in the success of the investment strategy.

First, a bit about the study: Vanguard needed to do something about the fact that the portfolios they looked at—both in terms of their composition but importantly in terms of how their owners ran their accounts (e.g., keeping steady or actively trading them) were all over the map.

Vanguard acknowledged the impossibility of accurately comparing these portfolios to meaningful benchmarks. Which benchmark, after all, matches John Doe’s personal rate of return, taking into account his original balance and cash-flow patterns? Even John might not know what his rate of return is supposed to be.

So Vanguard measured its customers’ IRAs against two “benchmarks” that are relevant comparisons only in the sense of being “something to measure against.” Those measures were a hypothetical mix of three stock and bond index funds and a target-date fund matching each account’s age cohort.

Vanguard compared actual returns with returns that would have resulted had the investors been invested in these two benchmarks (with the same starting balance and cash flow patterns).

The study period—the five years from 2008 to 2012— included the wild swoons of the 2008-2009 economic crisis.

What Vanguard found was that “hands off” investors did well, but those who switched their portfolios’ investments did not.

“The average investors who made even one exchange over the entire five-year period trailed the Vanguard asset allocation benchmark by 104 basis points annually …and trailed the Vanguard Target Retirement Fund benchmark by 150 basis points,” Weber writes. “On the other hand, investors who refrained from such activity beat the Vanguard asset allocation benchmark by 33 basis points annually and only lagged the Target Retirement benchmark by 19 points.”

Further, Weber found that “the majority of investors in our sample who chose to make [portfolio changes] would most likely have been better off in the Vanguard Target Retirement Fund hypothetical alternative during this period.”

That is because even disciplined investors who strayed from their equity allocation in their mixed stock-bond portfolio might lack “the willpower to rebalance back into stocks at the bottom of the market,” something that a sophisticated target-date fund does automatically regardless of market conditions.

Vanguard’s study reinforces the notion made famous by Charles Ellis that investing is a loser’s game that is won by not committing errors. It backs the idea that trading is a dangerous business.

But since a large number of investors don’t use target-date funds, or might pull the plug on their investments if they’re scared enough, attention should be given to the report’s two concluding sentences—almost an afterthought it seemed:

“Alternatively, self-directed IRA investors not invested in all-in-one portfolios who are convinced that their asset allocation is appropriate for their investing goals and time horizon might seek the services of an investment advisor. Such advisors ‘can act as emotional circuit breakers in bull or bear markets by circumventing their clients’ tendencies to chase returns or run for cover in emotionally charged markets’ (Bennyhoff and Kinniry, 2013).”

Behavioral finance experts have often noted the effectiveness of having advisors act as gatekeepers between an investor and his portfolio. As Meir Statman put it in a Research Magazine interview last year:

“Clients are their own worst enemies. They come to advisors to tell them when to buy and when to sell, and what to buy and what to sell. But that’s not what advisors can do–period.  Advisors cannot beat the market. But they can prevent clients from doing really stupid things. If advisors have that kind of conversation with clients, both would benefit.”

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