The Float

Target-Date Funds Under the Microscope

Not enough time this afternoon to give this the full treatment (in part because Typepad just ate the first version of this post, which, yes, is a problem that's easily overcome with a preemptive copy-and-paste...but still...very annoying). But we ran across two items interesting pieces on target-date funds, which have been frequent topics of discussion in this space for three primary reasons:

1. They're increasingly prominent features of defined-contribution plans, and thus increasingly important ingredients in the future retirement security of millions of Americans.
2. Like 401(k) plans themselves, target-date funds are loaded with potential...and plagued by a few non-trivial (and easily avoidable) shortcomings, most of which can be traced back to non-fiduciary practices in the financial services industry and lack of awareness among sponsors and participants.
3. Whenever fund companies get excited about selling a particular type of product, it's time to add an extra layer of vigilance.

We'll have some analysis of these two pieces as soon as time permits (tomorrow morning's looking good from here). Until then, both are worth a few minutes of your time if you're interested in such things: "Twelve observations on target date funds" and "New Study Finds Target Date Industry Has Serious Shortcomings."

Alpha and Beta Exposures

We've argued repeatedly that investors and advisors should be more aware of the distinction between alpha (idiosyncratic, manager-driven returns that are relatively uncorrelated to any underlying asset class or benchmark) and beta (systematic, market-driven returns that track underlying asset classes or benchmarks).

Two recent items suggest that such awareness is on the rise among institutional and individual investors. Here's an excerpt from Pensions and Investments:

Some institutional investors are betting on highly concentrated equity portfolios to gain more alpha while at the same time expanding allocations to their core passive strategies, according to consultants, managers and pension fund executives.

As global equity markets are showing signs of a lengthy slowdown and investors are more cautious about costs, a new approach to the traditional core-satellite strategy is spreading across the world. The idea is anchored on the premise that investors in active equity strategies that hug a particular benchmark might be paying for alpha but getting mostly "closet" beta, consultants and managers said.

Another contributing factor is the poor performance of enhanced indexing and quantitative risk-control strategies. Once considered as a reliable way of harvesting alpha, many of these strategies -- which tend to make a large number of small bets against an index -- have nosedived in performance, driving investors to seek different sources of return, consultants said.

According to proponents of the updated core-satellite approach, investors should use a largely passive core portfolio coupled with more concentrated bets to maximize alpha in a cost-efficient way by using one or more concentrated managers.

And here's more from Advisor Perspectives:

Distinguishing alpha from beta matters because fees for beta from well-established asset classes should be very low, while fees for alpha are very high. Furthermore, you should select alpha providers carefully so the fees are worth it! Separating alpha from beta (in a clearly defined measurement or evaluative sense, not necessarily by investing separately in them) insures[*] you will pay high fees only for positive expected alpha, not for the delivery of a beta along with random, unskillful alpha production.

The point here isn't to argue for some super-strict separation in which alpha-seeking instruments must have zero beta (which, even if theoretically possible, is vanishingly unlikely in practical terms). It's to argue that there's a lot of beta out there masquerading as alpha. Investors and advisors who know the difference, and resist paying for one while receiving the other, should do better, on balance, than those who don't.

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* Pedantic diction-related aside: The word here should be ensured, which implies making something sure, not insured, which implies the business of insurance.

Sources

Thao Hua, "Finding Alpha With Few Bets," Pensions and Investments, June 23, 2008

Robert Huebscher, "Don't Pay Alpha Fees for Beta Performance," Advisor Perspectives, July 8, 2008

Growth and Value

Sifting through a stack of old newspapers over the weekend, we ran across a Wall Street Journal story that gave us fits. This is the sort of work that diminishes public understanding of financial markets, products, and services. It's three weeks old, but we still feel obligated to shed some light on it.

In a "Fund Track" item on the allegedly mediocre year-to-date performance of several Fidelity mutual funds, Jennifer Levitz opens with this:

Last year, after being needled by analysts for lukewarm performance, Fidelity Investments seemed to regain its footing. But so far this year, only 39% of Fidelity's equity funds are among the top half of their peers, compared with 64% for the same time period last year, according to the Chicago research group Morningstar Inc.

So far, so good...if not especially interesting or important. But the last section of the story gets very strange indeed (emphasis added in bold):

Morningstar analyst Christopher Davis said the numbers may show that what worked for Fidelity last year isn't working this year. After a long dry spell, growth stocks, a Fidelity specialty, surged in 2007, only to stumble this year amid recent market turmoil. Growth funds seek companies that are expected to have outstanding earnings gains.

"The reason they looked so good last year is the same reason that this year they don't -- Fidelity leans toward growth," Mr. Davis said. While Fidelity has "every niche covered" in the fund world, "they need to strengthen" the other categories, he said, adding that Fidelity has many more large-company growth funds than large-company value funds -- which scout for undervalued, cheap stocks.

There are two problems here. First, Fidelity's underperformance most certainly isn't a product of its lean toward growth. Why not? Growth has outperformed value by a comfortable margin this year! Here are the year-to-date performance numbers for two ETFs representing large-cap growth stocks (through June 9th, the day before the Levitz piece was published, not including dividends):

• IVE (S&P 500 Value), -9.70%
• IVW (S&P 500 Growth), -3.77%*

So no, the problem isn't growth per se. But then even if growth had underperformed value, that still wouldn't make the point Levitz seems to want to make. After all, Morningstar's comparisons are within categories (i.e., style boxes), so if Fidelity's three flagship growth funds (Magellan, Contra, and Growth)are lagging, they're doing so relative to other large-cap growth funds, which makes the value/growth comparison moot.

So the story is misleading on two levels: the relative recent performance of growth and value and the nature of the comparisons introduced in the opening paragraph.

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* Through Friday's trading, the year-to-date numbers were -16.93% for IVE (value) and -8.48% for IVW (growth).

Source

Jennifer Levitz, "Fidelity Stumbles in Bid to Regain Footing," Wall Street Journal, June 10, 2008

Learning from Bill Miller

In yesterday's reading list, we included a recent New York Times piece on Legg Mason's Bill Miller, the renowned fund manager whose flagship fund beat the S&P 500 for 15 consecutive years, from 1991 through 2005.

The story's premise--that Miller has been chastened a bit by his fund's recent underperformance--is fascinating enough as a study in manager psychology. More interesting (to us, anyway!) is the fact Geraldine Fabrikant's piece features a few arguments that we've made repeatedly in this space.

First, there's the big picture phenomenon of reversion to the mean. In relatively efficient markets, it's just enormously difficult to sustain significant departures from the performance of a fund's underlying asset class. Many efficient-market absolutists will suggest that Miller's successful run may well have been little more than coin-flipping luck. With so many managers in the field, they might say, a small number of coin-flippers will come up heads 15 times in a row. We think there is such a thing as investment skill, often more temperamental than technical. But we fully acknowledge that luck is part of the game as well, and we suspect Miller was both good and lucky for many years. There's no reason to suspect he's any less skilled now than he was five years ago, but his randomized draws from the bag full of luck has clearly turned against him.

Second, there are the intertwined problems of asset bloat and market impact. Here's Fabrikant:

SOME longtime market experts think that fund size is the most daunting challenge he faces. Regardless of periodic ups and downs, he may simply be managing too much money to continue to produce outsized gains, they say.

"The number of investment opportunities just shrinks radically" when a fund swells, says John C. Bogle, the founder of the Vanguard Group, the mutual fund powerhouse, who describes himself as a fan of Mr. Miller. "The bigger you get, the fewer the number of stocks you can hold with a meaningful position."

Indeed, Mr. Miller holds a relatively concentrated portfolio, and the bad news has kept coming for some of his major picks. Last week, after Microsoft's proposed buyout of Yahoo fell apart, Yahoo's stock plunged 11.5 percent last week. Legg Mason holds a 6.7 percent stake in Yahoo. Countrywide Financial, another big holding, has been slammed by the mortgage crisis and errant lending. Its stock has fallen 87.9 percent over the last 12 months. And Mr. Miller amassed a sizable position in Bear Stearns, the investment bank gone to the grave.

We remember one of Miller's annual letters in which he freely acknowledged the constraints of running a portfolio that was at once enormous and highly concentrated. (He was aware of the problem then, but, in Fabrikant's telling, seems to dismiss it as a cause of his recent underperformance.) Because asset bloat is a structural problem, there's not much he can do about it, unless he diversifies his holdings. Which he and his team appear to be considering:

At Legg Mason, Mr. Miller has been stress-testing his investment theses -- the way he and his colleagues picks stocks -- and is considering a move away from concentrating his bets on dozens rather than hundreds of stocks.

"The question we are asking ourselves is: Should we think more broadly now about probability, about high-impact events and protecting against them by having broader exposure to the market?" he says.

Which leads us to the third point: Chasing "hot" managers is not a particularly wise game, at least not after they're both hot and pretty much universally recognized as such. Paying managers to pick positions and manage risk actively isn't inherently unwise, but it should be done with great care, and such services should be delivered in products and programs that have a relatively high probability of delivering what investors are paying for. There can be no guarantees, of course, but piling into enormous funds with a relatively high likelihood of mean-reversion strikes us as an approach that makes a difficult game that much harder.

Source

Geraldine Fabrikant, "Humbler, After a Streak of Magic," New York Times, May 11, 2008

Cash Levels and Active Management

In yesterday's reading list, we mentioned a Jonathan Burton story on varying levels of cash in mutual funds. Burton mentions a few funds that have maintained relatively high levels of cash in recent weeks, noting that some of these funds have performed well even as the equity markets have rebounded off their January and March lows.

Here are a couple relevant excerpts:

The volatile stock market and the weak economy have derailed many mutual-fund managers, but without the ability to bet against stocks, some are playing defense the only way they can -- by holding more cash.

In recent months that's been a smart move. Cash is king when stocks head south. A sizeable allotment to short-term Treasury bills and other cash-equivalent vehicles can dodge the worst blows of a down market and absorb its unpredictable shocks. Moreover, money on the sidelines lets a cost-conscious manager scoop up bargains as they appear.

...

Yet this seemingly safe route is not without its own risk. Cash is trash when stocks rebound. Clinging to cash at those times creates a drag that can transform a leading fund into a laggard. Since no one knows when markets will turn, and given the constant pressure -- from both their shareholders and their bosses -- to outdo a benchmark index, most fund managers stay as close to fully invested as possible; the average diversified U.S. stock fund keeps only about 4% of its assets in cash, according to Morningstar.

Financial advisers in particular look askance at funds with outsized cash positions. Advisers set and adjust portfolio allocations between stocks, bonds, cash and other investments based on a client's risk profile. A cash-rich fund can upset those plans, says Dan Moisand, an investment manager at Spraker Fitzgerald Tamayo & Moisand LLC in Melbourne, Fla.

"If you're hiring managers to buy and sell stocks, that's what they should be doing," he says. "We should be making the cash decisions, because we're closer to the client."

Now, this leads to an interesting and important discussion.

In one sense, Dan Moisand is entirely right: Advisors are closer to their clients, and they should make the big asset allocation decisions. But there's another sense in which we think Moisand is on the wrong track.

When clients want active management (i.e., the explicit pursuit of alpha through some combination of outperformance in strong markets and capital preservation in weak ones), we think they should get it in a framework that's meaningfully different from the typical mash-up of active and passive exposure delivered by conventional long-only funds.

One of the key differences between tracking-error minimizers and true active managers is that the latter are less constrained than the former, in particular in the sense that their investment mandates do not require them to be (more or less) fully invested in all market conditions. After all, money management is risk management, and managing risk can be done in one of two ways: (1) strategic asset allocation and radical diversification or (2) active hedging of one sort or another (using options, short positions, cash levels, &c.). Both methods are perfectly legitimate. But they're different! And they need to be understood, pursued, and sold differently.

Burton's certainly right that large cash positions can weigh on performance during strong market episodes. But the essence of successful money management is in delivering market-beating returns for the same level of risk or market-like returns for a lower level of risk.

If advisors are frustrated with fund managers who maintain high cash levels (or whose cash levels vary somewhat unpredictably), they should look elsewhere for pure asset-class exposure, in particular to the inexpensive ETFs and index funds designed to provide exactly that.

If they want active managers, and are willing pay for same, they should know that varying levels of exposure to risky assets is part of what any self- and investor-respecting money manager should deliver.

Source

Jonathan Burton, "Kings of Cash," MarketWatch, May 11, 2008

401(k) Fee Disclosure

We don't understand--in fact, we don't come close to understanding--industry arguments that enhanced disclosure of 401(k) expenses would somehow be counterproductive.

Yes, getting the numbers exactly right is pretty much impossible. Helping sponsors and participants understand what they're getting for what they pay will take some work--and, given the pervasiveness of non-fiduciary practices in the retirement plan marketplace, some serious explaining. 

But when we dust off our econ textbooks, they seem to say something about information being an important component of functioning markets. Let's get the information out there. Let's help people understand it. Let's facilitate meaningful competition among industry players. Who'll benefit? Everyone. Everyone, that is, except for those who prefer to conceal their non-fiduciary practices.

Reader PM tipped us off to this editorial in Sunday's Los Angeles Times. It's spot on:

Faced with an aging workforce, corporate America has tried to cut costs by making employees take responsibility for funding their retirement. Pensions, or "defined benefit" plans as they're known in the parlance of chief financial officers, are becoming a relic of the Industrial Age. In their place, employers are offering 401(k)s, or "defined contribution" plans. And increasingly, they're passing all the costs associated with those plans on to Jack and Jill Cubicle. Companies may kick in some dollars to match workers' savings, but the burden is on employees to set aside part of their paycheck for their dotage.

Unfortunately, as this newspaper detailed in a series of articles in 2006, many employees aren't being told how much of their nest egg is being frittered away on fees paid to the companies managing their 401(k)s. Buried in the fine print of incomprehensible forms or not disclosed at all, those fees can consume thousands of dollars over time. To address that problem, several lawmakers have introduced bills that would require mutual funds, insurers and other providers of retirement plans to make complete disclosures of their fees to employers and workers. The House Education and Labor Committee gave its blessing last week to one by Chairman George Miller (D-Martinez), H.R. 3185, which would also require companies to offer workers the chance to invest at least part of their 401(k)s in a low-fee index fund to avoid potential liability for losses.

The measure has drawn stiff opposition from securities firms, which have complained that employers and workers would be confused and even deterred by a detailed disclosure of the various categories of fees. Some would prefer to reveal just the fee total. That would be a step forward, but supplying a detailed breakdown would also help employers and workers compare different providers' charges for the same administrative services. Those comparisons could prod employees to demand better deals and give employers the leverage to negotiate them.

Miller's proposal may be made moot by new regulations promised by the Labor Department and the Securities and Exchange Commission that would mandate more disclosure of investment fund fees. But Congress shouldn't trust the Bush administration or the SEC to act. Arrangements between employers and retirement plan providers that hide fees from those who pay them prevent market forces from holding down those charges. If employees are picking up the tab, they should have a range of options for their 401(k) contributions. And none of those options should be able to conceal the amount that would be burned off in fees.

All that is true enough. But as we've argued before, what matters is participants' outcomes. All else equal, low, transparent expenses are good. We think they're necessary (but not sufficient) components of fiduciary plans. After all, if defined-contribution plans continue to push investment management responsibility down to rank-and-file participants, our retirement savings system will come up short of its great potential.

Source

"Make 401(k) fees transparent," Los Angeles Times, April 21, 2008

Funds and Taxes

Back on April 3rd, The Wall Street Journal ran its quarterly section on funds (mutual and exchange-traded), one part of which was the now-standard "How Well Do You Know" feature. These quizzes are generally interesting and useful, but they always seem to include passages that don't ring quite right. Two such items stood out this time.

First, there was question five: "True or false: ETFs are always more tax-efficient than comparable index-oriented mutual funds." The answer, of course, is false. ("Always" is a high bar to clear!)

In their explanation, authors William Power and Leslie Scism point to ETFs' creation-redemption process as a key reason for their superior tax-efficiency. But then they quote Morningstar's Jeff Ptak, who's been mentioned in this space before:

"Generally speaking, one would expect an ETF's arbitrage mechanism to make it more tax-efficient than a rival open-end index mutual fund," says Morningstar's Jeff Ptak. "However, one wouldn't ordinarily expect these differences to be enormous, as [indexed mutual] funds are low-turnover portfolios to begin with," meaning that they aren't typically racking up big realized capital gains.

There's certainly some truth to that. More or less by definition, low-turnover portfolios should realize fewer capital gains (and offsetting losses) than high-turnover portfolios. But we don't think Ptak's point gives enough weight to the fundamentally different processes driving mutual funds and ETFs. In the case of index-based mutual funds, the portfolio itself will be relatively low-turnover. But that's not the only thing that matters, because the redemption activity of some shareholders can create tax implications for all.

A hypothetical: Even if an S&P 500 index fund doesn't change its constituents at all from one year to the next, an open-end fund based on that index can still distribute capital gains to all shareholders due to the redemption activity of some shareholders. This is one reason we prefer ETFs to open-end funds. Not only is the vehicle itself better designed for tax-efficiency per se; it also puts the investor in charge of his or her tax destiny. Bottom line: With open-end funds, tax implications are functions of the fund manager's buying and selling and of other shareholders' buying and selling.*

Second, there was question seven: "What is the best way to avoid finding yourself in a mutual fund that makes big taxable distributions?" Answer: "Buy a fund that has investors pouring in new money." Here's the explanation from Power and Scism:

If you want to find a fund that's tax-efficient, look for one with big cash flowing in. Those big inflows mean that, by year end, the dividends and realized capital gains earned earlier in the year are distributed over a larger number of shares. By contrast, funds closed to new investors don't get the dilution effect that comes with all that new cash sloshing into a fund, so they often are tax-inefficient.

This strikes us as wrong on two levels: (1) it puts the tax cart in front of the investment horse and (2) it encourages a generally counter-productive brand of self-dilutive performance-chasing. After all, which funds are likely to have "investors pouring in new money"? The hottest funds most prone to mean-reversion. This notion of chasing new money into hot funds doesn't strike us as particularly logical or helpful for rank-and-file investors.

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* Savvy handling of tax lots can help fund managers minimize distributions, but that has its limits.

Source

William Power and Leslie Scism, "How Well Do You Know...Funds and Taxes?" Wall Street Journal, April 3, 2008

Closet Indexing: Worse Than We Thought?

We've used this space to draw attention to an under-appreciated problem in financial services: big, diversified mutual funds that behave more like their underlying benchmarks than true instruments of "active management." (Click here for an August post that links to a couple other items we've written on this topic.)

In the March issue of the Exchange-Traded Funds Report (subscription required), we ran across an intriguing passage in the edited transcript of a roundtable discussion of the ETF marketplace. Here's the exchange, between a questioner and panelist Joe Keenan of Bank of New York Mellon (emphasis added in bold):

Audience Member: It occurs to me that the traditional mutual fund industry--should they choose to monetize their cash position using ETFs--could double the size of the industry. I know some funds are indeed using ETFs as a vehicle they're investing in.

Keenan: I'll make one comment only because we do have some intelligence at The Bank of New York Mellon. Just for kicks we run reports as a custodial bank to see who's holding ETFs, and it is extraordinary how many traditional long-only mutual funds hold ETFs, either to equitize their cash or to get the market return and then just layer on fees. You may not see the ETFs held during the reporting periods, but certainly inside those periods. It's not uncommon.

A couple comments. First, it's not inherently wrong for mutual fund managers to equitize cash with ETFs. Depending on a manager's investment discipline and conditions in the relevant asset class, it can be perfectly sensible to combine a set of active opportunities and ETFs for portfolio completion (i.e., a fully- or almost fully-invested fund). We've done as much in our own active program.

But Keenan's remarks reveal a couple serious--and potentially related--problems: (1) reporting-period manipulation designed to conceal the fact that managers are equitizing assets using ETFs and (2) the cynical laziness of earning market returns and layering on active-management fees. To the extent that a manager is guilty of (2), he/she/they might use (1) to conceal the ruse.

To summarize: Using ETFs to equitize assets can be a perfectly sensible periodic/short-term tactic. But as ever in this business, we prefer more transparency to less, and thus less subterfuge to more. If managers are using ETFs in their active portfolios, they should freely acknowledge as much, explain their decision-making, and be accountable for their results. Anything less is a breach of managers' fiduciary duty to fund shareholders.

Source

"Past, Present & Future of Exchange-Traded Funds," Exchange-Traded Funds Report, March, 2008 (subscription required)

Watch That Tracking Error

We've never understood--or, to put it more precisely, we've never seen the value of--the money management industry's emphasis on tracking error in long-only funds. Minimizing tracking is a perfectly reasonable objective. But to do so, investors should (more or less) eliminate it by using index-based vehicles.

Where investors want active management of some sort, on the other hand, tracking error per se should be viewed as a decidedly positive characteristic--as long as it isn't consistently to the downside, of course. Managers who are compelled (by institutional consultants, retail advisors, in-house mandates, and/or their own insecurity) to minimize tracking error have little opportunity to deliver what they've been hired to do, which, presumably, is to deliver something other than the fully commoditized returns of some particular benchmark.

We were reminded of this important idea yesterday by Yves Smith, who passed along a recent FT story on "innovation stagnation" in the mutual fund industry. Here's a key exceprt from Kevin Burke's piece in the FT:

The US mutual fund industry’s best attempts at innovation have fallen flat in recent years due to a hairy mix of factors ranging from changes in how funds are distributed to the simple fact that many new products have failed to deliver their promised returns.

Compounding the lacklustre output is the industry’s maturity level. With all the major asset classes already chock full of choices, there is little room for more products on shelves that are stocked with 7,044 mutual funds.

...

A big factor in the innovation stagnation is the fact that so-called gatekeepers at the broker/dealers whose financial advisers sell funds have gained much greater influence over what those advisers sell. These gatekeepers are paid to sort through the thousands of funds available. And they want predictability in the funds they recommend.

Specifically, gatekeepers do not want to see more than 3 per cent tracking error, or deviation from the relevant benchmark funds are supposed to track. It is an attempt to manage risk and avoid negative surprises. Their job is on the line if the funds they recommend do not deliver as promised. Innovative products, by definition, are not going to be predictable.

...

The safe bet for portfolio managers is to stay close to their benchmark. The rub for investors is they end up paying a higher fee for active management when what they are essentially getting is an index fund.

As always, we don't stake any theological claim on behalf of active or passive styles. We use both, and we think each can play an important role in a comprehensive asset management program. What we are committed to, both in theory and in practice, is that those two styles should be pursued (and understood) very differently. Where the passive approach is strategic, highly diversified, tax-efficient, and inexpensive, the active approach should be tactical, relatively concentrated, eclectic, and a little more expensive.*

These two styles, the relative merits and demerits of which have prompted endless debate, are, if nothing else, different. Rather than pushing ugly mashups of active and passive styles in the form of big, bloated, highly diversified mutual funds, the kind of industry "creativity" Kevin Burke finds wanting should manifest itself in an honest telling of this important distinction.

Alas, we won't be holding our breath...

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*It should be a little more expensive if it's good. If it's good, it's scarce, and thus deserving of a premium price. But not, we hasten to add, a ridiculously high one.

Source

Kevin Burke, "Fads dominate as creativity fails," Financial Times, March 2, 2008

Another Weak Target-Date Fund

Three weeks have elapsed since we last took up the issue of target-date and other fund-of-funds vehicles. So we thought it was about time to take another crack at these things. Today's object lesson: Vanguard's Target Retirement 2050 Fund.

We have three primary objections to these instruments:

• Inadequate or inappropriate exposure to global asset classes
• The inclusion of weak (or worse) proprietary funds alongside better ones*
• Sub-optimal rebalancing procedures

We'd add high explicit and implicit expenses, but that's a problem with mutual funds in general, not target-date funds in particular.

So how does the Vanguard 2050 Fund stack up? First, we want to be very clear about this: Vanguard is about as client-friendly as an outfit can be. The company's long-standing commitment to low-cost, low-BS investing has given it a fully-deserved reputation as an industry leader.

And on the question of expenses, Vanguard's 2050 Fund's 0.21% expense ratio is absurdly cheap. No problem there. But as we've mentioned in this space, low costs are just one (very important) part of the equation. The other part? Getting the investment strategy--the asset allocation, the rebalancing, the choice of investment vehicles--as right as one can get it. In other words, we'd rather have an optimal mix of investment with slightly higher costs than a sub-optimal mix at rock-bottom costs...because the (negative) compounded "cost" of having the wrong mix can far exceed the (positive) compounded effects of lower expenses.

We can't speak to Vanguard's rebalancing process at the moment (because we're having a heck of a time opening the prospectus...we'll try again later). And Vanguard 2050 clearly isn't stuffed full of under-performing, unsellable proprietary funds. So that leaves us with the fund's asset allocation. Let's take a look...

Now, our most aggressive portfolios don't include any fixed-income positions, but a 10% allocation to the asset class is a relatively minor quibble. We would point out that we think any long-term fixed-income exposure must include some non-U.S. exposure, preferably including emerging markets debt.

But let's focus on the most glaring fact here: With roughly half of global market cap existing outside the U.S., one of the world's greatest indexing shops--a shop, in other words, that places great emphasis on market cap per se--wants its youngest, most aggressive investors to have less than 20% exposure to non-U.S. equities, less than 4% of which is in emerging markets, where, whatever short- and medium-term volatility may pop up from time to time, long-term growth prospects far outstrip the developed markets.

In addition, to break away from established cap-weighting, one might want a little more exposure to small- and mid-cap equities, both domestic and international. Here again, a supposedly evidence-based operation, by leaning overwhelmingly on its Total Stock Market Index Fund, denies its passive, long-term investors the opportunity to benefit from the long-term outperformance of smaller-cap stocks.** Of course the Total Stock Market fund does provide some exposure to small-cap equities, but shouldn't long-term investors have at least a marginal overweight in the asset class? We think so. Vanguard, apparently, does not.

Here's our point: Target-date funds are elegant in their simplicity and, in Vanguard's case, in their low costs of ownership. But too many target-date funds, even those provided by investor-friendly shops like T. Rowe Price and Vanguard, suffer from problematic investment mandates that seem likely to keep their shareholders from enjoying the full benefits of a long-term, pension-caliber investment.

One might wonder why this is the case. After all, these outfits employ some of the brightest, best-educated, most sophisticated minds in the business. This is unadulterated speculation, and we offer it very guardedly, but if one "follows the money," one might suspect that fund providers might prefer lower short-term volatility (whatever the implications for long-term returns might be) to the alternative of higher short-term volatility, which might shake shareholders, and the fees they pay, out of the funds in question.

If anyone has a different theory, we'd love to hear about it.

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*Why? Often because the fund company has a tough time selling its inferior funds outside the outwardly desirable and increasingly popular target-date framework. Just another example of Wall Street's sales objectives trumping investor interests...

**Yes, that outperformance is historical, and may not repeat itself. But the the same thing can be said for the benefits of indexing, which, in general, we celebrate. Ultimately, history--and a little theory--is all we have to work with, and it provides a perfectly sensible rationale for overweighting small- and mid-cap stocks, especially small-cap value stocks, in any long-term portfolio.