You have an important decision to make: Index or active TDF

August 28, 2020

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Active versus passive isn't a new debate in the investment and retirement plan industry. A quick web search will find pages of results showing a wide range of research articles to opinion pieces arguing for or against the merits of each investment strategy.

78 in 2019 callout

It's a good conversation to have when so much is at stake. The decisions plan sponsors make regarding the funds offered in their retirement plans will impact their employees' retirement. With the rise of target-date funds (TDFs), about 78% of all participants in Vanguard plans used a TDF in their portfolio in 2019.¹ The choice between a passive and an active TDF for your retirement plan is one of the most important decisions you can make.

It's worth noting that there's no such thing as a purely passive TDF because glide-path construction and sub-allocation decisions are active choices. TDFs can be built with broadly diversified index funds as the underlying investments, like Vanguard Target Retirement Funds. Why do we choose an index fund approach to TDFs instead of active funds? Because we believe our index funds provide participants with expertly constructed portfolios that can help them meet their retirement goals in a highly transparent and low-cost investment vehicle.

Hard to maintain outperformance

One consideration for active TDFs is that they create the opportunity to outperform the market. While it's true that there is a chance for active to outperform, research shows the chances are slim that a manager can do it consistently year after year. That's especially true the longer the time frame, making it that much harder to outperform with a TDF considering they are generally held over multiple decades.

Percentage of funds that underperformed their benchmark

Source: S&P SPIVA Scorecard, December 31, 2019. The chart includes the universe of funds in the S&P fund categories.

"One of the questions a plan sponsor has to ask themselves is what are they going to do when an active manager starts underperforming," said Brian Miller, a senior product manager in Vanguard Portfolio Review Department. "It's very difficult to find skilled managers who can beat the markets consistently, so how long will you stick with an active fund when that inevitable streak of underperformance occurs?"

Factor in the higher costs of an active manager through higher management fees and more frequent transaction costs cutting into potential returns, and it becomes even more difficult to find a manager who can consistently deliver higher returns.

Passive TDFs help participants during the pandemic

Of course, 2020 brought a new challenge for retirement plans in the form of the coronavirus pandemic. With the spread of COVID-19 came market volatility and the temptation to make trades or even abandon equities. Our research shows, however, that Vanguard participants with TDFs by and large embraced the long-term strategy championed by passive TDFs and did not panic. In fact, in the first four months of 2020, only 1.7% of participants who are invested in a single Vanguard TDF made an exchange, which was five times lower than other investors.²

Not only did Vanguard TDF investors refrain from panicking, but performance in the Vanguard Target Retirement Income Fund also surpassed industry averages.

Performance during notable equity market drawdowns

COVID Performance

The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors' shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. Visit our website at institutional.vanguard.com/performance for the most recent Vanguard investment performance.
Sources: Vanguard and Morningstar, as of June 30, 2000.

"It's our mission to provide every participant with the best chance for investment success," Miller said. "Not just when times are good, but especially in times of volatility when investors need us the most. Vanguard Target Retirement Funds are built with this in mind and are constructed based on investment best practices, including the principles of asset allocation, diversification, transparency, and a balance among risk, return, and cost."

Reducing risk through transparency

Adding active TDFs to a plan's lineup wouldn't just introduce the potential for outperformance, it also increases the amount of risk the plan is taking from a litigation standpoint. Not only do active TDFs run the risk of not paying off in higher performance, they have also been the subject of a recent rise in 401(k) lawsuits. If you go back to those web searches, another common retirement plan topic you'll find is a rise in 401(k)-related lawsuits.


Brian Miller Quote Callout

"Participants are taking action and plans are being sued for a variety of reasons, including fees and investment underperformance. While some firms may tout complexity, we believe our prudent and straightforward approach not only helps participants meet their goals, but can reduce unnecessary risk," said Miller.

So if you find your investment committee debating index versus active target-date funds, make sure you ask the right questions:

  • How many months of underperformance are you willing to withstand?
  • What is your litigation risk tolerance?
  • And most importantly, what's best for my participants?

These are all vital questions you have to answer when making one of the most important decisions for your plan.

To learn more about Vanguard Target Retirement Funds, visit our funds page.

You can also read our research, Vanguard's Approach to Target-Date Funds.


¹ Source: How America Saves 2020.
² Source: How America Saves 2020.

Notes:

  • For more information about any fund, visit institutional.vanguard.com or call 866-499-8473 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss in a declining market.
  • Past performance is not a guarantee of future returns.
  • Investments in Target Retirement 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 Retirement Fund is not guaranteed at any time, including on or after the target date.
  • Vanguard is responsible only for selecting the underlying funds and periodically rebalancing the holdings of target-date investments. The asset allocations Vanguard has selected for the Target Retirement Funds are based on our investment experience and are geared to the average investor. Regularly check the asset mix of the option you choose to ensure it is appropriate for your current situation.