Building Your Own Target-Date Fund

I'm 30 years old and recently rolled my savings from a 401(k) into an IRA. I had been investing in a target-date retirement fund. But now that I have virtually unlimited investment options, I'm wondering whether I should just create the same portfolio using individual funds or ETFs. What do you think? -- Brandon L., Rochester, N.Y.

Essentially, you're asking whether you're better off building your own target-date retirement fund or buying one off the shelf.

While you might be able to lower your expenses and thus boost your return with the DIY approach, it depends on how much you have to invest, which funds or ETFs you choose and how much work you're willing to put into building and managing your own target-date portfolio.

To illustrate, let's take a look at the Vanguard target-date fund designed for someone your age, the Vanguard Target Retirement 2045 .

This fund invests 90% of shareholders' money in stocks and 10% in bonds by divvying up its assets among three Vanguard index funds as follows: total stock market index (63% of assets), total international stock index (27%) and total bond index (10%). To invest in this fund, you pay annual expenses of 0.19% of assets, or $19 per $10,000 invested.

You could create a virtually identical portfolio by just investing your money in a total stock market index, a total international stock index and a total bond market index fund in the same proportion a target fund holds them. But you wouldn't necessarily save any money by doing so.

Related: What is an index fund?

Why? Because if you prorate the expenses to reflect the percentage that each fund would represent in your portfolio -- 63% of the total stock market index's 0.18% annual expenses, 27% of international stock fund's 0.22% cost and 10% of total bond market's 0.22% expense ratio -- you end up with pretty much the same 0.19% in total expenses. (I say "pretty much" because the total bond market fund in the target date fund isn't available to individual investors and has slightly different expenses than the one that is.)

But there are a few ways you may be able to pay less.

One is to invest in the same three underlying index funds, but buy a different share class of those funds.

When Vanguard assembles its target portfolios, it uses "Investor" shares. Vanguard has a cheaper version -- called "Admiral" shares --but doesn't use them in its target portfolios. You, however, can build your own target fund with the cheaper Admiral shares.

There's one, rub, though: Each of the Admiral shares requires a $10,000 minimum initial investment, as opposed to a mere $1,000 minimum for the target-date fund.

As a practical matter, that would mean you would have to create a portfolio with at least $100,000 in assets in order to meet the $10,000 minimum for the bond index fund, while at the same time assuring that the bond fund represents no more than 10% of your portfolio overall.

If you can clear that hurdle, duplicating the 2045 target fund with Admiral shares would reduce your annual expenses by almost half from 0.19% to 0.10%. But while that represents a nearly 50% reduction in expenses, in dollar terms we're not talking about a huge difference: about $90 a year for every $100,000 invested. Whoopee!

The second way you might be able to do better is by building the equivalent of a target fund portfolio with ETFs, which many firms, including Vanguard, allow you to buy without paying trading commissions.

Vanguard requires only a $3,000 minimum investment to open a brokerage account and invest in ETFs, so by going with ETFs you can get around the $10,000 minimum for Admiral shares.

And since Vanguard's fees on the Admiral share and ETF versions of its total stock market, international stock index and total bond index funds are identical, you could reap the same savings in annual expenses as with the Admiral shares. (Vanguard's brokerage firm levies a $20 annual fee for accounts with balances under $50,000, but you can sidestep that by agreeing to electronic delivery of confirmations and statements.)

There's one other move you could try: Going with the funds or ETFs of another firm, such as Fidelity or Schwab, both of which have been chipping away at the fees on their index funds and/or ETFs.

For example, Schwab now charges just 0.04% for its version of a total stock market index ETF and 0.05% for its total bond market index ETF. Schwab doesn't offer the equivalent of a total international stock index ETF that includes small-caps and emerging markets, but you could cobble one together by combining a few separate international Schwab ETFs.

I estimate that by mixing and matching various Schwab ETFs, you could create something close to the Vanguard target-date fund for roughly 0.06% in annual expenses. That's about 40% lower than the 0.10% or so that you would pay with Vanguard ETFs.

Again, though, the dollar savings won't exactly blow you away.

Even on a $100,000 investment, the difference would be about $130 a year vs. the Vanguard 2045 target fund and $40 compared to a DIY target portfolio made up of Vanguard Admiral funds or ETFs. In fact, the savings could be even smaller, as ETFs have other potential costs such as the bid-ask spread and the extent to which the ETF sells at a discount or premium to net asset value.

Which brings us to the larger question: Does it really makes sense to go to the trouble of creating your own target-date portfolio?

The idea behind these funds is simplicity and ease.

A target fund gives you a diversified portfolio of stocks and bonds appropriate for your age and shifts more of its assets to bonds as you age so your savings are less vulnerable to stock-market shocks as you near and enter retirement. They're not perfect, but target funds can provide a reasonable investing strategy that many investors may not be able to come up with or stick to on their own.

If you build your own target portfolio, you have to set your asset allocation and maintain a "glide path," or gradually move out of stocks and into bonds.

Even if you mimic a target-date fund for someone your age, you've still got to do the work. That will include periodically selling shares to rebalance the mix between domestic stocks, international shares and bonds. If the funds are held outside a tax-advantaged account, such sales could mean paying tax on realized gains.

Bottom line: If you're investing a large sum and willing to monitor and fine tune your homemade target fund, then I suppose the potential savings you can reap might be worth it. But for the overwhelming majority of investors considering a target-date fund, I think buying a target fund off-the-rack is a more realistic approach.