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These Vanguard funds are perfect for an indexer. Here's the catch

Andrew Hallam is the index investor for Strategy LabGlobe Unlimited subscribers can view his model portfolio here and read more in the series online here.

When I was a kid, elementary school dances were a really big deal. The teachers set up two sets of benches on opposite sides of the gym. There were rules. Girls sat on one side of the gym. Boys sat on the other. Those with the guts to get off the bench actually got to boogie.

Sometimes, it was "girls choice." Us boys had to wait for a girl to ask us. I'm sure everybody relates to what sometimes happened next. Somebody you liked headed straight toward you. But at the last possible second, they turned around or asked someone else.

It's a metaphor for life. Perhaps that's why Charles Dickens's Great Expectations became such a classic. We sometimes build up hopes just before they pop. Vanguard Canada broke my bubble just a few weeks ago. It announced it would offer Target Retirement Funds to institutional investors. I e-mailed them like a giddy little kid. "When will they be available to retail investors?" The rep dumped me gently. "We should get together for coffee sometime," he wrote. "But I have to tell you. We won't be introducing such funds to retail investors any time soon."

Vanguard has been selling Target Retirement Funds to Americans for years. My wife owns one. They're portfolios of indexes rolled into a single fund. They're offered to British investors. They're offered to Australians. But Canadians get snubbed. That's a shame because I think they're the world's best investment products.

There are three keys to investment success. The first is a rising market over time. The second is a low-cost portfolio. The less you pay in fees, the more you get to keep. The third, and most important, is investors' behaviour. This might sound controversial, but fees are the only things that investors can control. As a group, investors behave badly.

Morningstar proves it. The fund-rating agency determines how much a fund would have gained if an investor bought and held it. They then compare those results with how investors in each fund performed. For example, Vanguard's S&P 500 index averaged 6.89 per cent a year (measured in U.S. dollars) during the 10-year period ended March 31, 2016. But the average investor in the S&P 500 didn't come close to earning that. They averaged just 4.52 per cent per year. They preferred to buy on highs. They added less on lows.

Vanguard's Total International Stock Market Index Fund averaged 1.88 per cent over the past 10 years. Its typical investor averaged just 0.91 per cent.

Investors in Vanguard's Total Bond Market Index Fund underperformed as well. The fund averaged 4.75 per cent. Its typical investor, over the past 10 years, averaged just 4.21 per cent.

This might sound like an argument for investing in actively managed funds with an adviser at the helm. But I don't think so. In December of 2014, I looked at one of the biggest actively managed mutual-fund companies in the United States. It's called American Funds. Investors can't buy these funds on their own. They must use a broker or adviser. Using Morningstar's data, I wanted to see whether such investors captured more of their funds' returns than a typical do-it-yourself investor with index funds.

I checked four equity-fund categories: U.S. Large Cap, Emerging Markets, Broad International equity and Small Cap equity. Despite having a financial adviser to guide them, during the 10 years ended Oct. 31, 2014, the average American Fund investor underperformed the funds they owned by an average of 1.75 per cent a year. Investors with Vanguard (most of whom are DIY investors) underperformed their funds, in the same equity categories, by an average of 0.46 per cent per year.

The gap between a fund's posted return and how much its investors make increases during market volatility. The past decade was a litmus test. We had the crash of 2008-09 slapped in the middle.

But investors in Vanguard's Target Retirement funds rose to the occasion. Because they had entire portfolios rolled into single funds, they never had to worry about which index funds to buy. Nor did they have to worry about when to rebalance. Vanguard did it for them.

In fact, the typical investor in these funds outperformed the funds themselves by an average of 0.75 per cent a year. There's only one possible reason. Most of these investors practised dollar-cost averaging. That means they added the same amount of money every month. This enabled them to purchase fewer units when the markets rose and more units when the markets fell. Vanguard's automatic rebalancing also ensured that more money went into stocks when stock markets fell and more money went into bonds when stock markets rose.

One company does offer similar funds in Canada: Tangerine. They cost a lot more than what American, British or Australian investors pay for their Vanguard products. Tangerine's funds charge management fees of 1.07 per cent. In contrast, my American wife pays 0.14 per cent for her Vanguard Target Retirement 2020 fund.

But, like my wife, investors in Tangerine's funds don't have to speculate which fund to buy next. They can confidently add more money every month. They never have to worry about rebalancing their portfolios. Tangerine does it for them.

Odds are, despite their higher costs, Tangerine's investors will outperform most DIY index-fund investors.

But investors could pay less. Come on Vanguard. Ask us all to dance.

Vanguard Target Retirement Funds

FundAnnual Fund PerformanceAnnual Investors’ PerformanceAnnual Advantage
Target Retirement 20155.30%5.42%0.12%
Target Retirement 20255.37%5.96%0.59%
Target Retirement 20355.40%6.47%1.07%
Target Retirement 20455.48%6.71%1.23%

Source: Morningstar.com

Measured in USD.

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