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Best target-date funds? Fidelity vs. Vanguard

Reprinted courtesy of MarketWatch.com.

To read the original article click here

Target-date retirement funds are everywhere these days, offering investors a one-decision solution that supposedly will take care of most, if not all, of their investment needs for life.

It’s an appealing pitch, and the selection of such a fund can have huge lifetime consequences. Yet most people make this decision casually — or in the case of 401(k) programs, they passively let others make it for them.

Though many companies offer these funds — and more new ones are coming out all the time — the lion’s share of the business is owned by Fidelity and Vanguard.

For this article, I analyzed eight target-date funds: Four from each company, with target dates of 2020, 2030, 2040, and 2050.

The assets in the portfolios of each set of comparable funds are very similar. But the results for investors are quite different between these two big fund families. 

If Vanguard and Fidelity operated as close competitors, say along the lines of Verizon versus AT&T in the mobile phone market, the choice between the two fund families would be casual, perhaps a matter of convenience.

But Fidelity, which has the larger share of assets, charges its target-date customers considerably more — and therefore (predictably) offers considerably less.

The reason for this disparity is really quite simple, and there’s nothing hidden about it.

You can argue about this six ways to Sunday, but the laws of mathematics prevail: In mutual funds with nearly identical portfolios, the shareholders who pay higher costs inevitably receive lower returns.

In a nutshell, Fidelity’s target-date fund shareholders pay considerably higher expenses than the shareholders in Vanguard’s target-date funds. Vanguard shareholders get higher returns.

Fidelity: The Fidelity Freedom K 2020 FFKDX, +0.13% 2030 FFKEX, +0.13% 2040FFKFX, +0.18%  and 2050 FFKHX, +0.18%  funds have average expenses of 0.61% and average compound returns (for five years ending March 31, 2015) of 9.3%. Fidelity has about $50 billion in assets in these four funds. Applying each fund’s expense ratio (they vary from 0.57 to 0.66) to its assets, I believe Fidelity shareholders are paying about $295 million a year for these funds.

Vanguard: The Vanguard Target Retirement 2020 VTWNX, +0.20% 2030VTHRX, +0.23% 2040 VFORX, +0.26%  and 2050 VFIFX, +0.26%  funds have average expenses of 0.17% and average compound five-year returns of 10.4%. The assets in these four funds total about $81.7 billion. Applying individual expense ratios (they vary from 0.16% to 0.18%) to the assets in each leads me to believe Vanguard shareholders pay about $138 million a year.

These numbers make it look like Vanguard is the 500-pound gorilla in the target-date fund world. But Fidelity also has target-date funds designed for IRAs and taxable accounts (Fidelity Freedom 2020 FFFDX, +0.19% et. al.), and these add another $34 billion in assets. The four funds in this series have average expenses of 0.75%, bringing another $251 million in revenue to Fidelity.

That means shareholders pay Fidelity $500 million a year to manage $84 billion. Vanguard shareholders, on the other hand, pay the company only $138 million to manage $82 billion in funds with similar asset allocations and levels of risk.

An obvious question: Do Fidelity shareholders get extra value for the extra money they pay. The obvious answer is no; in fact, it’s just the opposite.

To understand this, imagine you can choose between two essentially identical funds — except for one important difference. Each fund deducts a “users tax” from your account; this “tax” is three times as high in the first fund as in the second.

That’s the way mutual fund expenses work, and in this example the first fund would be the Fidelity fund. When you pay more, you get less.

And in fact that’s exactly what the numbers show.

Looking at the 2020 funds, Vanguard charges expenses of 0.16% and had a five-year compound return of 9.27%. Fidelity Freedom K charges expenses of 0.57% and had a five-year return of 8.16%. Fidelity Freedom charges 0.67% and had a five-year return of 8.05%.

The relationship holds for 2030, 2040 and 2050 funds as well. The average expense ratio of four Vanguard funds is 0.17%, while the average five-year return was 10.4%. For Fidelity Freedom K funds, expenses average 0.61% and the five-year return averaged 9.3%. The Fidelity Freedom funds had average expenses of 0.75% and average five-year returns of 9.18%.

I am not in the business of promoting Vanguard, and I have nothing against Fidelity. What you are reading is based on facts reported by Fidelity and Vanguard to their shareholders.

Why are Fidelity expenses more than three times as high as Vanguard’s for managing essentially identical portfolios? I think there are at least three important reasons.

First, Fidelity pays active fund managers to try to beat the market. These are bright, expensive employees whose compensation burdens the expense ratio of every fund except index funds. Vanguard funds have managers, of course, but their job is much simpler: To follow indexes.

Second, Fidelity must make profits for corporate shareholders. Vanguard, on the other hand, is owned by the shareholders in its funds. Operating profits go right back to those shareholders.

Third and perhaps most important, Fidelity charges higher expenses (and thus delivers lower returns) simply because it can. For reasons beyond the scope of this discussion, corporate retirement plan trustees choose Fidelity more often than they choose Vanguard.

Fidelity’s massive marketing blitz imbues its funds with an aura of specialness that, though it doesn’t deliver the goods, makes retirement plan trustees and investors feel comfortable.

Fidelity target-date funds aren’t bad. They just cost more. And because of that, those funds don’t give shareholders the full returns they should receive for the level of risk they are taking.

You may not have a choice of target-date fund families. But if you do, the numbers indicate without question that you are likely to receive higher returns at Vanguard than at Fidelity.

If you want to learn more listen to my podcast “Ten advantages of Vanguard funds.”

I will be speaking in Ventura, California on May 7 and again in Portland, Oregon on May 16. Each presentation lasts three hours.

Richard Buck contributed to this article.