Approximating Vanguard target date funds

 seeks to help investors who are saving and investing in an employer provided plan and are interested in approximating Vanguard target date funds based on the available funds.

If you are fortunate enough to have an employer plan that provides a wide selection of low-cost asset class index funds, you will likely succeed in closely approximating the target date fund with a limited number of funds.

However, many investors are forced to participate in plans that have high costs, plentiful fund offerings but few index fund options. In this environment, crafting the simple, low cost approximation can be a more difficult task. The investor might need to supply the additional total market positions in other accounts.

This article first describes he principles of the approximation. Next, total market funds are explained and their approximation is introduced. Finally, a comprehensive example is shown. Several scenarios requiring approximation of total market funds are portrayed.

Principles of
The Vanguard target date retirement funds are four-fund portfolios. The four asset class index funds making up this buy-hold-and rebalance portfolio are: The Vanguard Target Retirement Income fund, as well as the funds that are closing in on their target dates add a fifth fund, the Vanguard Short-Term Inflation Indexed Bond Index, to the portfolio mix.
 * A US total stock market index fund
 * A total international stock market index fund
 * A US total bond market index fund
 * A total international bond market index fund

The allocations of target date funds change over time. An investor approximating the target retirement funds will need to change its allocations every 5 years according to the table 'target retirement funds - Detailed fund allocations

Prior to Vanguard's addition to international bonds, the target funds held the three-fund portfolio without international bonds. Investors approximating the target retirement funds, but not desiring to hold international bonds, can replace these international bonds with domestic bonds.

Constituent total market funds
The three-fund and four-fund portfolios have one thing in common: Every index fund name contains "total." This section defines the "total" index fund compositions.

US total stock market funds
These funds invest in the investable US public stock markets, weighting stocks according to their market capitalization. They will include large-cap, mid-cap, and small-cap stocks. The percentage of stocks in each weighting category is shown in the table below, known as a Style box. Summing all categories equals 100%.




 * + Total US Stock Market Index Fund Style Box (%)
 * align="center" style="background:#f0f0f0;"|Value
 * align="center" style="background:#f0f0f0;"|Blend
 * align="center" style="background:#f0f0f0;"|Growth
 * align="right" style="background:#f0f0f0;" | Large Cap||align="center" | 26||align="center" |22||align="center" |24
 * align="right" style="background:#f0f0f0;" |Mid Cap||align="center" |6||align="center" |6||align="center" |7
 * align="right" style="background:#f0f0f0;" |Small Cap||align="center" |3||align="center" |3||align="center" |3
 * }
 * align="right" style="background:#f0f0f0;" |Mid Cap||align="center" |6||align="center" |6||align="center" |7
 * align="right" style="background:#f0f0f0;" |Small Cap||align="center" |3||align="center" |3||align="center" |3
 * }
 * }

Approximating US total stock market funds
A commonly encountered situation for many retirement plan investors is to find only an S&P 500 index fund in their retirement plans. To attain total market exposure, the investor would need to add a completion index fund, or a combination of mid cap and small cap index funds.

In some instances, investors may have these funds within their plans. The Thrift Savings Plan, the federal workers retirement savings plan, for example, offers both an S&P 500 index fund and an extended market completion index fund. Some plans may also offer a mid cap index fund and a small cap index fund in addition to the S&P 500 index fund, which opens up the opportunity to approximate the US total market. If the plan does not have suitable options to capture the rest of market, investors may be able to do so by:
 * 1) Investing in these completion indexes in a personal retirement plan or taxable account;
 * 2) Forgo investing in the S&P 500 fund and hold the total market fund allocation in a personal retirement plan or taxable account.
 * 3) If married, invest in these completion indexes in the spouse's accounts.
 * 4) If married, forgo investing in the S&P 500 fund and hold the total market fund allocation in one of the spouse's accounts.

Total international stock market index fund
The most complete total international index funds invest in both developed market and emerging market stocks, and hold market allocations to large-cap, mid-cap, and small-cap stocks.

Approximating total international stock market index fund
Some international index funds will only cover developed markets, and many international index funds only include large-cap and mid-cap stocks. In these instances, investors may consider adding emerging market and small cap international index funds. Depending on the specific indexes used for developed markets and emerging markets, a complete replication of the total market could require the addition of a Canadian and South Korean index fund.

The approximate breakdown between developed market, emerging market, and global-ex US small cap stocks is:
 * Developed market: 65%
 * Emerging market: 20%
 * Global ex-US small cap: 15%

Depending on the availability of emerging market and small cap international index funds, investors might be able to add them in their employer's plan, in their individual retirement plans or taxable accounts, or if married, in their spouse's accounts. An additional option is to forgo investing in a developed market index fund and hold a total international index fund in another account (if married, this can also include a spouse's account).

Total US bond index funds
In the US, a total bond index is commonly benchmarked to the Barclays Capital US Aggregate Bond Index, which benchmarks investment grade taxable bonds. These include treasury and government agency bonds, investment grade corporate bonds, mortgage-backed securities and asset-backed securities. The index does not include Treasury inflation protected securities, high yield bonds, floating rate bonds, or municipal bonds. The total US bond market index has an intermediate term duration.

Total international bond index funds
Most forum investors will be considering the Vanguard international bond index fund, which is hedged against currencies, and invests in international government, agency, and corporate bonds, primarily from developed countries. The index has an intermediate term duration.

Example of approximating a Vanguard target date fund
Below is an illustrative example, as of August 31, 2013, which builds a target date fund asset allocation from a 401(k) plan's list of available funds. The plan has:
 * A lot of choices.
 * Target retirement funds, but in this case they would be deemed inappropriate because they are Fidelity Freedom® Funds that use 24 active funds.
 * A Balanced fund, Fidelity® Four-in-One Index Fund, which approximates three quarters of the Vanguard target retirement fund (lacks international bonds) but comes with the limitation of having only one asset allocation (85% stocks/ 14% bonds).
 * U.S. and international stock total market indexes and a US bond index that match three quarters of the Vanguard target retirement fund and fulfill the requirements for a three-fund portfolio.
 * A developed international market index.
 * Additional bond indexes.

(Open table for a complete listing of fund choices and expense ratios.)

Goal
The following examples use an asset allocation of 60% / 40% stocks to bonds. By design, Vanguard allocates 28% of a target date fund's stock allocation to international stocks and allocates 20% of a portfolio's bond allocation to international bonds. The Vanguard Target Retirement 2020 Fund (VTWNX) is the closest match and is composed of the following total market index funds:

The last 2 columns show which funds are categorized as stocks or bonds. Asset allocations only need to be within 5 %, so this target retirement fund is suitable for a 60 / 40 portfolio.

The scenarios below are documented in the following Google spreadsheet:

Approximating the U.S stock market allocation
This plan holds a total U.S. stock market index fund. Replace the Vanguard funds as shown in the spreadsheet under "A total US stock market fund is available." Since a total international bond market index is not available, one option is to use the US bond index fund in place of the international bond index fund. Round the asset allocations to the nearest 5%.

The following scenarios show how to approximate the U.S. total market segment, if we assume that the plan did not provide a total U.S. stock market index.

No U.S. total stock market index fund is available (completion index)
If the plan did not hold the U.S. total stock market index fund, an investor could use the available completion index fund and reconstitute the total US market slice of the portfolio as follows:

S&P 500 index fund with completion index fund. The total market approximation split would be:
 * S&P 500 index: 80% of the US stock allocation
 * Completion index: 20% of the US stock allocation.

Refer to in the spreadsheet under "If a total US stock market index fund is not available (Completion index)." These percentages are calculated from Morningstar's [http://portfolio.morningstar.com/Rtport/Free/InstantXRayDEntry.aspx? Instant X-Ray]. In this case, entering FXSIX (holding value of 80%) and FSEVX (holding value of 20%) will result in a Total US Stock style box that's very close to the one shown above.

Split the US total stock market index share by these percentages as shown:


 * S&P 500 index: 34.8% = 80% of 43.6%
 * Completion index: 8.72% = 20% of 43.6%

Extra precision (more decimal places) is used to show the methodology. Round the final asset allocations to the nearest 5%. In this instance the rounded allocations would result in an allocation of:


 * S&P 500 index: 35%
 * Completion index: 10%

No U.S. total stock market index fund is available (small-cap and mid-cap)
If the plan held neither the U.S. total stock market index nor the completion index fund, the investor could use the available small-cap and mid-cap index funds to approximate the US total market index:

S&P 500 index fund with a mid-cap index fund and a small-cap index fund. The total market approximation split would be:
 * S&P 500: 80% of the US stock allocation
 * Mid cap index: 5% of the US stock allocation
 * Small cap index: 15% of the US stock allocation.

Refer to in the spreadsheet under "If a total US stock market index fund is not available (Mid-cap, small-cap)." As stated previously, use Morningstar's [http://portfolio.morningstar.com/Rtport/Free/InstantXRayDEntry.aspx? Instant X-Ray]. In this case, entering FXSIX (holding value of 80%), FSCKX (holding value of 5%), and VSCIX (holding value of 15%) will result in a Total US Stock style box that's very close to the one shown above.

Split the US total stock market index share by these percentages as shown:


 * S&P 500: 34.88 % = 80% of 43.6%
 * Mid cap index: 2.18 % = 5% of 43.6%
 * Small cap index: 6.54% = 15% of 43.6%

Extra precision (more decimal places) is used to show the methodology. Round the final asset allocations to the nearest 5%. In this instance the rounded allocation would be:


 * S&P 500: 35%
 * Mid cap index: 5%
 * Small cap index: 5%

No U.S. total stock market index fund is available (S&P 500 index only)
The plan only has an S&P 500 index fund and neither of the above funds are available. In this case, the investor would need to use a completion index fund, or a combination of small-cap and mid-cap index funds held in other accounts (personal retirement accounts, a taxable account, or if married, one of the spouse's accounts to approximate a total market position.

Otherwise, use the S&P 500 index fund.

In addition, an investor might decide to totally forgo investing in the plan's US stock funds, by holding the US stock allocation in another account (or if married, in a spouse's account.)

Approximating the international stock allocation
This plan holds a total international stock market index fund; which is shown in the spreadsheet under "A total US stock market fund is available." .

The following scenario shows how to approximate the international total market segment if the plan did not provide a total international index fund.

No total international stock market index fund is available
The plan has developed market index fund (SPTN International Index ADV (FSIVX)).

To partially reconstitute an approximation of the total international fund, the investor would invest in the developed market index fund (FSIVX) but would need to add an emerging market index fund to the portfolio in another account. To more fully reconstitute the total market approximation, the investor would also need to add a global-ex U.S. small cap international index fund in another account. In this particular scenario, as the plan's developed market index tracks the MSCI EAFE index, the allocation lacks exposure to Canada. If the added emerging market index does not include South Korea, this nation would also be missing from the allocation.

In addition, an investor might decide to totally forgo investing in the plan's international stock funds, by holding the international allocation in another account (or if married, in a spouse's account.)

Approximating the U.S. bond allocation
This plan holds a U.S. total bond market index fund; which is shown in the spreadsheet under "A total US stock market fund is available."

The following scenario shows how to approximate the U.S. total bond market index, if we assume that the plan did not provide a total U.S bond index.

Refer to Inflation-protected securities for suggestions on incorporating inflation-protected bonds.

No U.S. total bond market index fund is available
The plan has a U.S. intermediate-term Treasury bond index fund available that provides the portfolio with an investment grade intermediate bond allocation. If the investor wishes to diversify the bond allocation, this can be accomplished by holding additional bond funds in other accounts.

In addition, an investor might decide to totally forgo investing in the plan's US bond funds, by holding the US bond allocation in another account (or if married, in a spouse's account.)

Approximating the international bond allocation
This plan does not provide an international bond allocation. The investor should add an international bond allocation in another account.

Alternatively, if one does not wish to hold international bonds, a U.S. total bond index, U.S. Treasuries, Inflation-protected securities or, in taxable accounts, tax-exempt bonds could be used to fill this allocation.