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Asset Allocation Funds: When Models Make the Tough

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April 25, 2003 — The bear market for stocks has been a bull market for bonds, so it’s hardly surprising that investors continue to deploy their holdings away from stocks in favor of fixed income securities. In 2002, stock fund outflows hit $27.1 billion, according to the Investment Company Institute.

But now, Treasury bond yields are at their lowest levels in 40 years, and market pundits are predicting that the risk of a sell-off in bonds is rising by the day. Meanwhile, stocks appear at least to be stable, and market strategists and money managers predict that they’ll wrap up the year with gains of between 7% and 8%, likely beating bonds.

“It’s probably the right time to be thinking about rebalancing, given that stocks are down about 50% from their peak,” says Evan Grace, market strategist at State Street Research. “Our view is that stocks will outperform bonds for the first time in four years this year — but since the magnitude of outperformance won’t be very great, it will be tough psychologically for investors to leave one asset class that’s done so well for another that might do only slightly better.”

But past stock market rallies have been short-lived, and investors remain fearful of the damage that could be done to stocks by the struggling economy, the aftermath of the war in Iraq, and the possibility of new terrorist attacks. Stuck between a rock and a hard place, they cling to Treasuries as the market that seems to carry the least risk.

But “crises set market bottoms, not market tops,” warns Duncan Richardson, chief investment officer at Eaton Vance. “While there’s still some ‘bubble trouble’ showing up in some corporate balance sheets, investors that don’t move out of Treasuries to some extent are running the risk that their portfolios will underperform.”

Enter the asset allocation funds, marketed to investment advisors and their clients as a way to solve the rebalancing dilemma. Fund families like them, as they can be marketed as a core holding in an effort to capture as much of an investor’s assets as possible. Meanwhile, the funds relieve investors and their advisors of the onerous task of making sense of the volatile moves in both stock and bond markets.

“These are going to be particularly attractive to the investment advisor who simply doesn’t have the time or resources to help each client review their asset allocation in response to every market move,” says Ellen McKay, managing director of the Optima Group Inc., a financial services advisory firm based in Fairfield, Conn. “It can be a great product to market to smaller investors who don’t feel the need to be actively involved in managing the details of their portfolio.”

Not surprisingly, the ranks of asset allocation funds are swelling in the current market environment. In March, Columbia Management Group announced the creation of the Columbia Thermostat Fund, designed to react to the changing market and marketed to clients disillusioned by the bear market and anxious to take the psychology out of investing. Late that month, Gabelli Funds LLC and Ned Davis Research Inc. launched the Ned Davis Research Asset Allocation Fund, which, in the words of Mario Gabelli, will offer investors “one-stop asset diversification plus quantitative controls on overall portfolio risk.”

These funds will join more than a dozen other offerings tracked by Standard & Poor’s FundAdvisor, including Fidelity Advisor Asset Allocation/A (FLOAX), PIMCO Funds:Asset Allocation/A (PALAX), Nations Asset Allocation/Inv A (PHAAX), Vanguard Asset Allocation/Inv (VAAPX) and Liberty Asset Allocation Fund/A (LAAAX).

All of these funds use quantitative models to determine how much of the fund’s assets should go into stocks, bonds or cash. Where the balanced funds stop with that allocation decision, however, the asset allocation funds go one step farther. Other models determine how much of the stock allocation should go to growth or value, and how much to small, mid, or large-cap stocks. In bond portfolios, holdings go beyond Treasuries to include investment-grade corporate bonds, junk bonds, and emerging markets issues.

But because these models vary widely — and lead to very different returns — it’s important that advisors know how they work, and what results they produce. For instance, while the ING UBS Tact Asset Allocation Portfolio/Adv (IUAAX) dropped 25.9% for the one-year period ended March 31 (thanks to what analysts call a heavier allocation to stocks than its peers), the PIMCO Asset Allocation Fund declined a more modest 14.1% over that period. There are numerous examples of mis-timed market moves dictated by the quantitative models. For instance, Vanguard’s fund was caught with hefty stock exposure during early 2001, denting its short-term performance.

Because the asset allocation decision is the most vital — and most personal — made by investors and their advisors in constructing their portfolio, asset allocation funds aren’t going to be the right fit for everyone. Add to that the fact that allocation fund managers can move entirely in or out of stocks, changing the risk profile of the portfolio, unlike a balanced fund, which keeps its allocation generally fixed.

“It’s hard to produce a ‘one size fits all’ asset allocation product,” says Richardson at Eaton Vance. “The danger of trying to deliver this allocation service is that you try to appeal to everyone, and do no one a good service. You don’t want someone buying a fund when it’s heavily in bonds being miserable and taking losses they can’t afford when it ends up with 80% in equities.”

Investment advisors who like the idea of putting asset allocation decisions in the hands of money managers have another weapon in their arsenal, however, the “timeline” funds. These funds are characterized by the date that is included in their name: for instance, the Scudder Target 2012 Fund (KRFCX), and the American Century Target Maturity 2025/Inv (BTTRX). Initially, these were bond funds, but the ranks of these funds now include asset allocation funds-of-funds, such as the Fidelity Freedom family — including Fidelity Freedom 2020 (FFFDX) and Fidelity Freedom 2030 (FFFEX — which invest in a range of other Fidelity funds.

“For a younger investor, the idea is that you’ve got a longer time horizon and can handle more volatility right now,” says Grace. “These are really only appropriate when someone has a high degree of certainty that they won’t need their capital until that target date.”

Regardless of whether the structure is an asset allocation fund or a timeline fund, investment advisors should be prepared for results that won’t keep pace with a raging bull market in either stocks or bonds.

“These are very sophisticated ways to manage risk, with something for everyone in them,” McKay says. “Now that people have realized they likely won’t make their fortune by investing in a couple of hot stocks, and there’s little confidence about the long-term outlook, there’s more focus on the advantage of diversification in general, and these products in particular.”