Investors face a growing number of options when choosing an asset allocation plan to power their investment portfolios.
Nearly 4,000 mutual funds and ETFs specialize in managing asset allocation in one form or another, and more than a dozen new ones launched in this year’s first quarter alone, according to Morningstar. The products are marketed under several labels, including asset allocation fund, balanced fund or the current favorite: target-date fund. By contrast, most other funds target specific asset classes — U.S. equities or foreign bonds, for example. Many specialize in subsets such as domestic small-cap value stocks or real estate investment trusts.
Investors or their financial advisers should keep asset allocation uppermost in mind when designing a portfolio. The first question to answer is whether to use several funds, each focused on a single asset class, or one asset allocation fund that offers a mix of asset classes. If you opt for an asset allocation fund, the strategy should match your financial goals.
“Asset allocation should be individually designed for each individual,” says Richard Ferri, founder of Portfolio Solutions, based in Troy, Mich., and author of several investment books, including “All About Asset Allocation.”
The importance of asset allocation
The stakes are high. Numerous studies over the years advise that asset allocation is a critical investment decision. Roughly 90 percent of a portfolio’s long-term investment performance is linked with the broad asset mix, research shows.
“The most important thing you can do to achieve success in investing is to get your portfolio’s asset allocation mix right and stick with it,” says Jerry Miccolis, chief investment officer of Brinton Eaton Wealth Advisors and co-author of “Asset Allocation For Dummies.”
Keeping the mix in sync with investment goals is a challenge for fund managers and do-it-yourselfers alike. Many studies show that keeping asset allocation from straying too far from the portfolio’s target mix can increase performance in the long run.
For example, consider a portfolio that’s set to 60 percent stocks and 40 percent bonds at the close of 2000. Suppose, too, that the equity allocation is equally divided between U.S. and foreign stocks. One version of the strategy is unmanaged, allowed to run without intervention. The other portfolio is identical initially, except that every Dec. 31 it is rebalanced to maintain the original 60/40 mix.
As shown in the accompanying chart, the rebalanced strategy performs better for the decade through the end of 2010, returning 4.9 percent per year, compared to 4.1 percent for the portfolio that’s not rebalanced.
Buying low, selling high
Rebalancing a broadly diversified portfolio across several asset classes “provides the investor with an automatic buy-low, sell-high bias that over the long run usually — but not always — improves returns,” writes financial planner William Bernstein in “The Investor’s Manifesto.”
Most asset allocation mutual funds rebalance. The details can vary widely. And because funds are managed for large groups of people, an individual investor’s needs may not be met.
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.