The Rise of Asset Allocation Funds

Asset allocation funds (target-risk, target-date, and other mixed-asset funds) use has risen since the recent market meltdown. While equity mutual fund investors headed for the doors in droves after getting pummeled during the Great Recession, many 401(k) participants and mutual fund investors have continued to add to their asset allocation funds.

REUTERS/Arnd Wiegmann

Despite that asset allocation funds experienced cumulative declines of 39.77% on average between October 9, 2007, and March 9, 2009, fund investors continued to inject net new money into asset allocation funds. From the beginning of 2008 through June 30, 2013, they invested a net $733.7 billion into this group, with target-date (lifecycle) funds taking in $264.1 billion, target-risk (lifestyle) funds bringing in some $139.7 billion, and other types of mixed-asset funds (primarily absolute return, global flexible portfolio, and flexible portfolio) attracting $329.9 billion of net new money.

Assets under management (AUM) for this group skyrocketed 141% from their $981.1 billion (about 9.9% of the U.S. open-end fund and variable insurance product [VIP] universes’ total assets) at the end of 2008 to $2.4 trillion (about 14.7% of all assets) at the end of June 2013. Target-date funds jumped 247% to $537.0 billion, target-risk funds increased 88% to $1.3 trillion, and the other mixed-asset funds group leapt 289% to $533.2 billion.

Source: Lipper

In their simplest form asset allocation funds combine multiple asset classes (stocks, bonds, and short-term investments) in a single portfolio, making them a simple and practical way to diversify investments. The funds tout benefits of asset class diversification, disciplined ongoing asset allocation (rebalancing), and a managed way to meet growth and income needs.

While some investors just threw in the towel and decided to let a professional portfolio manager run their money after the last market downturn, others were nudged along by Congressional decision-makers. Part of the growth trend in mixed-asset funds can be directly attributed to their use in defined contribution (DC) retirement plans. Under the Pension Protection Act of 2006, the U.S. Department of Labor designated target-date funds as one of the three qualified default investment alternatives (QDIAs), along with balanced funds (static-allocation or risk-based lifestyle funds) and managed accounts. (A QDIA is a default investment option chosen by a plan fiduciary for participants who fail to make an investment election for their account balances.)

The target-risk fund classifications have accumulated more assets than the other asset allocation fund groups, in part because they have been around a lot longer than their target-date or flexible portfolio brethren. Investors may recall the grandfather of these classifications: balanced funds. Historically, balanced funds had an investment strategy that committed the fund to investing 60% to 70% of its cash in dividend-paying stocks and the remaining 30% to 40% in fixed income assets. Today, in response to investors’ need for more risk-seeking and more risk-averse options, many fund families offer an array of professionally managed target-allocation portfolios that attempts to cover the risk spectrum by changing the stock/bond mix of different offerings and by maintaining target allocations that reflect tolerance for risk.

Many fund families offer several different portfolios with equity exposure ranging from some level of conservativeness to some level of aggressive growth. The distinguishing feature of these funds is the persistence of their allocation amounts. Whereas the target-date funds’ asset allocation mix automatically becomes increasingly more conservative with time as one approaches a stated target retirement date (often referred to as the fund’s glide path), in the target-risk lineup investors and their advisors have to determine their willingness to move toward a more conservative asset allocation model.  That isn’t done automatically.

Source: Lipper

Since 2006 target-date funds have climbed in popularity (remember QDIA). As a default investment for many 401(k) plans, the groups of funds that are keyed to five-year intervals are the fastest growing segment of employees’ 401(k) holdings. Over the last several years DC plans have gradually substituted target-date funds for risk-based lifestyle funds. The Investment Company Institute states that 91% of target-date mutual fund assets are held in retirement accounts, compared with 42% of lifestyle mutual fund assets.

Target-date funds are an attractive option for investors who don’t want to actively manage their own retirement savings. Target-date funds automatically rebalance to become more conservative as investors get closer to their retirement date or college enrollment date. Similar to their target-risk brethren, however, the fund group is not homogenous; glide paths differ significantly from each other. While one firm might believe an investor 50 years from retirement would be best suited with a 100% allocation to equities, another firm may believe that magic number is 85% (see the average glide path and disparity between the minimum and maximum amounts for stated five-year periods below and how the funds change over time). Perhaps most important though is the fund’s equity asset allocation percentage near the retirement date. In the 2007-2008 meltdown target-date funds with a large amount of equity compared to others with less exposure at the retirement date suffered larger market declines. While during good times larger equity exposure equates to better returns, the inverse should always be kept in mind. A particular fund choice depends on one’s risk tolerance.

Source: Lippery

One distinguishing factor  that investors should pay special attention to is whether the fund has a “to” or “through” focus, that is, does the fund reach the most conservative stock/bond ratio when the fund reaches its target year (a “to” focus), or does it reach that ratio after the target year has passed (a “through” focus). Both focuses have their pros and cons, and the final choice is usually based on which fund is being offered in a 401(k) plan, the investor’s risk preference, the actual withdrawal pattern, and the need for protecting against outliving one’s assets.

The last group of asset allocation funds, the “other mixed-asset” funds, has hit the ground running,  attracting the largest amount of inflows of the three groups and witnessing the most new funds over each of the last two years and for the beginning of 2013. The first classification in this group, based on a hedge fund-like strategy, is absolute-return funds, whose investment objective is to achieve a positive return in all markets. These funds generally do not try to beat some long-only market index but instead aim to outperform cash or some risk-free benchmark.

The last two other mixed-asset classifications are related, but one adds a global twist to the framework. Flexible portfolio funds and global flexible portfolio funds are the epitome of the go-anywhere style of investing. Investors in these fund classifications give the portfolio manager carte-blanche approval to invest in any domestic/global asset class the manager feels is appropriate for the existing market: stocks, bonds, cash, commodities, real estate investment trusts, and/or alternative investments. The manager may take long or short positions or use futures, options, and other derivatives to meet the fund’s investment goal or to manage portfolio risk. Often the yield on these funds is a little stronger than that of the other mixed-asset funds, and capital appreciation is an investment objective. These funds have not yet found their way into the 401(k) space as QDIAs.

While this article is too short to discuss all the issues surrounding asset allocation funds, here are some findings from our fundamental research: Investors are concerned about the large allocation to fixed income securities in their mixed-asset funds as the Federal Reserve readies the markets for an eventual “tapering” of its quantitative-easing measures. In a potential rising-interest-rate environment investors should expect target-date fund managers to start embracing adjustable-rate securities—such as bank rate loans—and to lower their duration. Target-date fund expenses declined in 2012, down 3.2 basis points (bps) to 0.991% for the average front-end load/no-load fund, 6.3 bps to 1.660% for the average back-end load/level load fund, and 4.4 bps to 0.912% for the average institutional fund. Exchange-traded funds and other passively managed target-date funds are growing in popularity (the differing one-year returns shown below lend support to this statement). Lastly, target-date funds are allocating a greater proportion of their assets to alternative investments, along with international and emerging-market debt and equity securities.

Source: Lipper

* This article originally appeared in the September 2013 issue of On Wall Street Magazine