To be fair, asset allocation funds have their place. "A lot of people don't have the time or expertise to put together their own tailored personal allocation and adjust it as the years go by," says Greg Carlson, a fund analyst at Morningstar. Other investors may not have sensible choices in their 401(k) plans. Or perhaps an asset allocation fund may be selected as a core holding, with the rest of the portfolio customized to suit individual needs.
Do-it-yourselfers should consider several key variables when designing an asset allocation strategy: their age, how much money will be needed in the future, investment goals (college funding vs. retirement, for instance), the time when the money will be needed, and risk tolerance -- or comfort with short-term market volatility. You can start the analysis with Bankrate's asset allocation calculator.
Ideally, those factors that match your profile will be satisfied in an asset allocation fund you choose, although you'll probably have to settle for a strategy that comes close to a custom design with a one-size-fits-all mutual fund.
When sorting through funds, start by analyzing the basics: the asset mix and how it's managed. The broad choices for investments are stocks, bonds, commodities and real estate securities, such as REITs, along with their various subcategories. Equally important is how the asset classes are managed. Some funds mimic market indexes while others involve active management. Likewise, some funds are conservatively run, with relatively minor adjustments. At the opposite extreme are managers making frequent and dramatic changes, which can boost return as well as risk.
Also, consider costs. Among the nearly 4,000 asset allocation funds tracked by Morningstar, expense ratios range from as low as 0.13 percent for the fairly conventional State Farm Balanced Fund (STFBX) to funds charging nearly 3 percent. Costs alone shouldn't dictate your choice, but the higher the expense ratio, the higher the hurdle for delivering satisfactory results.
For perspective, keep in mind that you can build a globally diversified strategy that holds all the major asset classes with exchange-traded funds for under 0.5 percent. For asset allocation funds with materially higher expense ratios, you should have a high level of confidence that the extra price is worth it.
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