If you are a Vanguard investor, or have read almost any commentary from us in the past, you probably know we are big believers in index investing. Because of this, we encourage investors to use index funds for the core of their portfolio or for their entire portfolio if they don’t have a strong conviction in an actively managed strategy.

The reason is fairly straightforward and explained in detail in a Vanguard research paper, The case for low-cost index-fund investing. My colleagues in the Investment Strategy Group recently released an updated edition of the paper here.

We are even stronger believers in the case for index fund investing when it comes to target-date funds. To understand why, it’s helpful to discuss what makes index investing so effective in general—a concept popularly called the Lake Wobegon Effect after the town in a popular public radio show where “all the children are above average.”

This town is, of course, fictional. Everyone can’t be above average, not even children. In the same way, all mutual funds can’t be above average and outperform their benchmarks—especially after investment costs, taxes, and other fees are considered.

We regularly observe this theory in practice, as seen in the figure below. Almost 58% of equity mutual funds underperformed their benchmarks in the 15-year period 2000 to 2015. The results for bond funds were even less impressive, with almost 73% failing to outperform. If we include funds that were closed or merged out of existence in these numbers, 60% to 80% of equity funds and over 80% of bond funds failed to outperform their benchmarks, depending on the category for each.

The distribution of equity fund performance

blog_wobegon_09122016

Sources: Vanguard calculations, using data from Morningstar, Inc. Displays the distribution of excess returns, net of fees, relative to their prospectus benchmark, for the 15-year period ending December 31, 2015. Results for other periods will differ. Past performance is no guarantee of future returns.

An examination of institutional share class mutual funds yielded better results for this period as the median equity fund in this category managed to generate 7 basis points (0.07%) of positive excess returns. That’s a relatively meager result when you consider the additional risks and due diligence involved. Further, this period is not consistent with other periods we examined, where, on average, even institutionally priced mutual funds tend to lag their benchmark’s performance by an amount roughly equal to their expense ratio.

The case for indexing becomes even more compelling in target-date funds when you consider the unique role that they play in defined contribution plans. Among Vanguard full-service recordkeeping clients as of the end of 2015, 41% have automatic enrollment features, where participants are directed into default investments by the plan sponsor. Within these plans, 95% of plan sponsors have selected target-date funds as their default. These facts mean about 21% of the participants at Vanguard have been defaulted into a single target-date fund (either index- or active-based) through the autoenrollment process.

While there is certainly nothing wrong with this trend from a regulatory perspective, it raises some interesting investment-related questions for plan sponsors. Is it a good idea to select actively managed target-date funds when, on average, the added risk and higher cost of active management has resulted in lower returns? Is this concern even larger for plan sponsors that automatically enroll participants in a single target-date fund when those participants have done little, if any, due diligence on the active manager?

The case for low-cost index fund investing is compelling, and we will continue to be a leading advocate for it in the industry. But we believe the argument for low-cost index fund investing is even more compelling for plan sponsors that use target-date funds as their qualified default investment alternative and automatically enroll participants in them. These participants are by definition unengaged in the investment selection process, and plan sponsors should carefully consider investment risks that, on average, have raised costs and lowered returns. Unlike the children of Lake Wobegon, all mutual funds can’t be above average. Plan sponsors should keep this in mind as they perform due diligence and select target-date funds for their plans.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a target-date fund is not guaranteed at any time, including on or after the target date.