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| The Basics | 4 ways to diversify investment risk
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Balanced, life stage, hybrid and asset allocation funds make for a smoother ride, even when the market is pitching and rolling. Here's how to pick the one that's right for you.
By Timothy Middleton
Wouldnt it be nice if you had managed to avoid the market carnage of the past three years? Even better, wouldn't you love to get only a single statement in the mail announcing the happy news? Thats how rich people do it -- investing with a family retainer who does everything from picking stocks and bonds to keeping tax records.
You dont have to be rich to have this kind of financial freedom, however. A host of mutual funds have sprung up in recent years to treat this multiple-financial-personality disorder. Called by a variety of names, from flexible and hybrid to life stage and asset allocation, they are designed to offer thorough, dynamic and professional diversification of all your assets.
You dont have to have a bunch of different funds, where you have to go out and pick the best funds in each category, says Tom Roseen, a research analyst with Lipper. Youre giving that privilege to a fund manager to allocate your portfolio.
But if flexible funds are designed to be no-brainers from their shareholders point of view, picking the right one for you takes some work. They come in at least four distinct flavors, from venerable balanced funds to newfangled varieties that become more conservative as you grow older.
But all share one trait: They have the flexibility to preserve and even grow your assets when markets are in turmoil. And turmoil is increasing -- the September-through-November period was one of the most tumultuous in financial history --so flexible funds are likely to become even more important in years to come.
Balanced funds and funds of funds
Taking a comprehensive view about managing all of a clients assets isnt a new idea in the mutual fund industry: American Funds American Balanced (ABALX), one of the largest of these traditional portfolios, was first offered to investors in 1933. Ever since, it has maintained roughly 60% of its assets in stocks and 40% in bonds.
That was an outstanding mix in 2000 and 2001: The American fund spurted 15.9% in 2000 and advanced a further 8.2% in 2001. Then in 2002, it lost about 6%, but that was much better than the market itself.
But balanced funds are required by their charters, as well as Securities & Exchange Commission rules, to hew closely to the 60/40 ratio, and most of them likewise stick to blue-chip stocks and gilt-edged bonds. So a newer hybrid has arisen to offer more flexibility.
These are typically funds of funds, such as Vanguard STAR (VGSTX). Rather than owning securities directly, it invests in other Vanguard funds. Not long ago, STAR was invested in 11 funds, with the typical 60/40 split, but not just blue chips: It held shares of Vanguard Explorer (VEXPX), a small-stock growth fund, and Vanguard International Value (VTRIX).
This solves the problem of allocating your assets within, as well as between, the major asset classes. Vanguards investment experts make decisions about favoring corporate bonds over governments, or small stocks over large, so you dont have to. This is a particularly attractive option for small investors.
Until your assets get beyond a couple of hundred thousand dollars, or youve developed a lot of investment acumen, you dont need any diversification beyond this, says David Diesslin, chief executive of an eponymous financial-planning firm in Fort Worth, Texas.
T. Rowe Price has developed two families of funds of funds. Three Spectrum funds invest in various Price funds representing domestic stocks, international stocks and bonds. They are free to move within their sectors, with T.Rowe Price Spectrum Growth (PRSGX), for example, cutting back on big-cap stocks and adding small caps at times like these, when the former are lagging and the latter leading.
Prices three Personal Strategy funds are balanced, but in varying proportions: T.Rowe Price Personal Strategy Growth (TRSGX) is only 20% bonds, T.Rowe Price Personal Strategy Balanced (TRPBX) is 40%, and T.Rowe Price Personal Strategy Income (PRSIX) is 60%. Each achieves these allocations by owning a variety of other Price funds.
When you are broadly diversified like this, you can put in some aggressive sectors individuals wouldnt necessarily choose for themselves, says Ned Notzon, president of both fund families. Spectrum Income, for example, is 3% invested in T.Rowe Price Emerging Market Bond Fund (PREMX), which is even more volatile than the S&P 500.
But it also has zero correlation with other bonds, so it doesnt add to the volatility of the mix, Notzon says. Each of the funds is less risky than the individual funds in which they invest.
Life-stage funds
The disadvantage of owning, say, Personal Strategy Growth is that at some point as you grow older, you would probably be better off migrating to Personal Strategy Balanced. But, outside a retirement account, that could create tax consequences. And you could also simply forget to do it. So some mutual fund companies have created portfolios that make these shifts automatically.
Fidelity Investments, for example, has a group of funds labeled "Freedom," created for the 401(k) market.
Upward of 40% of plan participants, no matter how many funds are offered, still only use one or two in their accounts, notes Drew Lawton, executive vice president of Fidelity Institutional Retirement Services. We felt we needed a good investment solution for those people so they could achieve the asset allocation and diversification that they should have, even by just using one fund.
The idea is that when youre young, you can afford to put up with the volatility of equity markets, but as you age you need to pay increasing attention to preserving your capital. So Fidelity Freedom 2040 (FFFFX), designed for investors who wont retire for 40 years, has only 9.8% of its assets in an income fund.
Fidelity Freedom 2010 (FFFCX), on the other hand, is for people nearing retirement. It holds more than 50% of assets in fixed-income funds, and its equity holdings are more conservative than 2040s. Fidelity Freedom 2000 (FFFBX), for people who have already retired, has nearly 30% of assets in a money-market fund and more than 40% in fixed-income funds.
The fund continues to hold equities because, Lawton says, When youre in your 60s you still need protection against inflation. The funds dont evaporate on their maturity date -- they just continue to become increasingly conservative. By the year 2010, the 2000 fund will be fully invested in the Fidelity Freedom Income Fund (FFFAX), which is only 20% equities.
Asset-allocation funds
Freedom and other so-called life-stage funds change their portfolios in carefully graduated increments over the years. Asset-allocation funds, by far the most flexible of this new generation of portfolios, make the changes day by day. And unlike Prices Spectrum funds, they move between, and not just among, asset classes.
Asset-allocation funds are derided by most investment professionals as market timers -- a skill so rare that academic research says it cant be done. They tend to generate a lot of taxes, and they do a lot of trading, and I dont think anybodys smart enough to overcome these costs, says John Markese, president of the American Association of Individual Investors.
But asset allocators see themselves differently. Exeter Blended Assets (EXBAX), which has earned Lippers highest ranking, called "Lipper Leaders," does not make macro market-timing calls. We use a very bottom-up incremental process, says Richard Barrington, director of client services of Manning & Napier Advisors, in Rochester, N.Y., which operates the fund.
Our mindset is, in order for us to buy a stock, its got to price out to have a higher return than the bond rate, Barrington says. As valuations go up, youll typically find yourself selling more than youre buying. When stocks get cheaper, youre buying more stocks and selling more bonds.
Managers of a pure equity fund dont have this luxury; theyre stuck with stocks no matter what. The bear market creamed them.
But when stocks are doing well, Exeter is free to follow them. We did a lot of buying at the end of September, Barrington says, when the bear market was bottoming in the wake of the Sept. 11 tragedy. The fund boosted its equity holdings to 48% of assets, from a low of 36% earlier in that year.
Balanced funds and most other hybrids are stuck with their allocation, and couldnt slash their stockholdings in the bear market, or boost them when a new bull was born in November. But the asset allocators, including Exeter, can, and this flexibility has paid off.
Flexible funds dont make good cocktail-party conversation; they dont shoot up 100%, or even 50%, in their best years. And in non-retirement accounts they can be tax-inefficient, because of bond yields and trading profits.
But they also dont go down 50% in a year. Their average performance in 2001, the worst market in a generation, was a loss of 3.9%.
Rather, the combination of profit potential and loss avoidance makes them good candidates for individual investors who dont have the skills, or the interest, in creating the same kind of thoroughly diversified portfolio from scratch. As Fidelitys statistics demonstrate, thats a lot of us.
At the time of publication, Timothy Middleton didnt own any of the securities mentioned in this article.
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