Delivering on design: Disciplined implementation in index-based target-date funds 

While evaluating a fund’s performance relative to its peer group remains a relevant and commonly cited measure, it is equally important to assess whether the fund has consistently delivered on its stated mandate with minimal unintended risk. In other words, did the fund stay aligned with its stated benchmark, control costs, and preserve the returns generated by the markets it was designed to capture?

At the core of every index-based TDF is its mix of stocks and bonds that the fund plans to hold by following its glide path. This structure defines the investment risks investors experience and the sources of long-term return. Trading costs, unintended tilts (for example, drifting away from the target allocation), and cash drag are not part of portfolio design. They are implementation frictions that factor into a fund’s relative return to its stated benchmark. What the glide path prescribes is not as simple as it seems.

On the one hand, investors expect the fund to closely follow its stated benchmarks. On the other hand, maintaining that precision requires trading, and trading is not free. Each rebalance introduces both direct costs and indirect effects, but delaying action can allow allocations to drift. A well-managed index-based TDF should seek to minimize these frictions while staying aligned with the stated benchmark. Tracking error is a common measure that reflects how closely a fund follows its benchmark. In practice, there is an art to balancing out these forces, with a natural tension between tighter tracking and lower costs, which is ultimately defined by the fund’s rebalancing approach.

How a manager navigates this trade-off directly shapes the consistency, transparency, and risk profile that plan sponsors and consultants ultimately valuate. Done thoughtfully, striking this balance translates into several clear benefits:

• It enhances predictability, helping the fund remain in line with expectations set at the time of selection.
• It supports stronger governance and fiduciary alignment by enabling committees to assess results against the strategy they approved—rather than having to explain unexpected deviations.

When evaluating index-based TDFs, their returns and volatility can be compared with a fully indexed market portfolio as a benchmark. Figure 1 shows the 5-year returns and volatility of Vanguard and competitor index-based TDFs relative to this benchmark, referred to here as the efficient frontier. The frontier represents the expected risk-return profile of a fully diversified market allocation across equities and fixed income and assumes no implementation frictions such as transaction costs. Outcomes that fall closer to the frontier indicate that a portfolio is capturing more of the market’s available return for a given level of volatility. Vanguard’s disciplined approach helps keep portfolios closely aligned with this benchmark, which delivered market-consistent returns with appropriately matched volatility. 

Rebalancing is a significant driver of a portfolio’s efficiency. While helping to maintain the portfolio’s structure, rebalancing is a primary source of trading costs and, therefore, a key driver of investment outcomes. While there can be a range of potential rebalancing policies across different index-based TDF providers, the two most common approaches in the industry are calendar-based and threshold-based rebalancing. Figure 2 illustrates the difference between these approaches. It shows a hypothetical 50% stock and 50% bond portfolio and the associated strategic asset allocation drift using a monthly calendar-based approach and a 200 basis points (bps, threshold)/175 bps (destination) threshold-based approach during the COVID-driven market volatility experienced in March 2020. 

In 2024, enhancements to our rebalancing policy for Vanguard Target Retirement Funds and Trusts included updating the target distance in our threshold-based policy and creating dynamic benchmarks that rebalance according to the same policy.

Our research shows that a threshold-based rebalancing approach can produce superior outcomes compared with a calendar-based approach by responding to market dynamics rather than a fixed schedule. Portfolios are monitored continuously, but trades are only triggered when allocations begin to fundamentally change the investment experience from the portfolio’s original expectations (beyond 200 bps from targets). When that happens, the portfolio is moved toward a specified destination (175 bps) rather than all the way back to target.

This approach helps improve efficiency in two ways. First, it reduces the frequency of trading by limiting activity to meaningful deviations. Second, it reduces the size of each trade by moving in increments and letting markets “rebalance” the portfolios. Because market impact tends to increase nonlinearly with trade size, breaking trades into smaller pieces can materially lower total costs. As highlighted in Figure 3, our estimates suggest a threshold-based approach can reduce rebalancing costs by approximately 70% to 80% across vintages, bringing annual costs closer to about 5 to 6 bps for portfolios typically part of TDF glide paths.