Personal Finance After 50 For Dummies - Eric Tyson

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approach a particular retirement date.

      Examining funds of funds

      Decades ago the mutual fund industry was beginning to reach critical mass and developing and expanding its fund offerings. The large fund companies soon had dozens of funds, and increasing numbers of investors found choosing among them overwhelming.

      Informed individual investors understood the concept of diversification and knew they should invest in a variety of funds that gave them exposure to different types of assets. And fund company representatives often found themselves being asked by investors for advice about what basket of funds they should invest in. So fund companies created funds of funds — that is, single funds comprising numerous companies’ funds.

      For example, consider the Vanguard Star fund, which was created in 1985. It’s made up of ten Vanguard funds, including domestic and foreign stock funds, bond funds, and a money market fund. Stocks comprise about 62.5 percent of the fund (and about 30 percent of those are foreign), bonds about 25 percent, and money market assets about 12.5 percent. Of course, one size doesn’t fit all, but for investors seeking global diversification and an asset allocation similar to this fund’s, Star offers low costs (its annual operating expense ratio is just 0.31 percent) and relatively low minimum investment amounts ($1,000).

In addition to the asset allocation, expenses, and riskiness of any fund of funds you may consider, also be sure to consider the tax appropriateness of the fund. Funds of funds that invest in bonds usually aren’t very tax friendly because they hold taxable bonds. Therefore, such funds generally only make sense inside of a retirement account or for lower-tax-bracket investors investing outside of a retirement account.

      Understanding target-date funds

      Target-date funds are funds of funds with a twist. Rather than maintaining a generally fixed asset allocation, especially between stocks and bonds, target-date funds adjust their mix over time.

      For example, the T. Rowe Price Retirement 2040 Fund is designed for investors expecting to retire around the year 2040. It invests in about 22 different T. Rowe Price stock and bond funds. Over time (and as you approach the retirement date of 2040), the fund reduces its stock exposure and increases its bond exposure. Thus, it reduces the riskiness of the portfolio.

      The risks of target-date funds are similar to funds of funds. The only additional risk of a target-date fund is if the fund manager tries to time the markets in his moves into and out of stocks and bonds and guesses wrong. The funds we recommend in this chapter don’t suffer this flaw.

      

Among the better target-date funds we’ve reviewed are

       Fidelity Freedom funds (www.fidelity.com)

       T. Rowe Price Retirement funds (https://individual.troweprice.com/public/retail)

       Vanguard Target Retirement funds (www.vanguard.com)

      Index and exchange-traded funds

      A simple, low-cost way to invest in stocks or bonds is to invest in what’s known as an index fund. These are passively managed funds that mechanically follow an index, such as one of the following:

       Bloomberg Barclays U.S. Aggregate Bond Index: A broad index that tracks the U.S. bond market.

       Standard & Poor’s (S&P) 500 Index: Tracks 500 large U.S.-headquartered-companies’ stocks.

       MSCI U.S. Broad Market Index: This index follows small, medium, and large U.S.-company stocks.

       MSCI Europe Index, MSCI Pacific Index, MSCI Emerging Market Index: These three indexes respectively track the major stock markets in Europe, the Pacific Rim, and in emerging economies, such as Brazil, China, India, and so on.

       FTSE All-World Index: A global stock market index.

      

All index funds aren’t created equal. How so? They do have these differences, so make sure you closely investigate any funds before you make an investment:

       Some have higher expenses than others. Lower costs, of course, are generally better when comparing index funds that track the same index (as long as the lower-cost index fund tracks its index well).

       Some indexes are likely to produce better long-term returns than others. For example, we have some concerns about the S&P 500 index because it’s a capitalization-weighted index. With this type of index, stocks hold a weighting in the index based on their total market value.For instance, during the 1990s, the technology sector’s stock weighting in the S&P 500 index ballooned from about 6 percent in 1990 to 29 percent by 1999. So investors buying into an S&P 500 at the end of 1999 had nearly 30 percent of their investment dollars going into pricey technology stocks. The financial sector experienced a similar ballooning in weighting before its steep price drop in the late 2000s.

      In addition to traditional index funds, some index funds invest in value-oriented stocks, which are those selling at relatively low valuations compared to the companies’ financial positions. Value-oriented stocks are far less likely to hold hot sector stocks destined to crash back to Earth. You also can use index funds that invest in equal weights in the stocks of a given index.

      Exchange-traded funds (ETFs) are index-like funds that trade on a major stock exchange. The best ETFs have even lower costs than index funds. But plenty of ETFs have flaws, such as higher costs or a narrow industry or small-country investment focus.

      

Here’s a list (in order from bond funds, U.S. stock funds, and then foreign funds) of index funds and ETFs that are our favorites:

       iShares Core U.S. Bond Aggregate (AGG): This ETF invests in investment-grade bonds and follows the Bloomberg Barclays Aggregate Bond Index.

       Vanguard Total Bond Market Index Admiral Shares (VBTLX): An index mutual fund that follows the Bloomberg Barclays Aggregate Bond Index. The ETF version (BND) has a slightly lower expense ratio.

       Vanguard Inflation-Protected Securities (VIPSX): This mutual fund, while technically not an index, largely follows the Bloomberg Barclays U.S. TIPS Index of inflation-protected bonds. Admiral Shares (VIAPX) has a lower expense ratio and a higher minimum ($50,000).

       Vanguard Small Cap Value ETF (VBR): This ETF tracks the value companies of the MSCI U.S. Small Cap 1750 Index.

       iShares Russell 2000 Index (IWM): This ETF tracks the Russell 2000 index of small-company stocks.

       iShares Russell 2000 Value Index (IWN): This ETF follows the Russell 2000 Value index, an index of small-company stocks.

       iShares Russell 1000 Index (IWB): An ETF that invests in the larger-company stocks that comprise the Russell 1000 Index.

       iShares Russell 1000 Value Index (IWD): This ETF follows the Russell 1000 Value Index, a larger-cap value index.

       Vanguard Total Stock Market ETF (VTI): An ETF that invests in small, medium, and large U.S. stocks.

       Vanguard Real Estate ETF (VNQ): This ETF follows the MSCI U.S. REIT Index, which invests in real estate investment trusts. You can also buy this as a fund — Vanguard Real Estate Index Fund Admiral Shares (VGSLX).

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