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Finding Balance With Standout Asset Allocation Funds: Mutual Fund Focus, February 2010

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News and analysis from Standard & Poor’s MarketScope Advisor

Investment guides and pundits are constantly reminding us that asset allocation is the single most important factor for successful investing. And since advisors and their clients who use mutual funds in their portfolio construction are already paying professional asset managers for their time and expertise, it stands to reason that asset allocation, in addition to stock picking, trade execution, cash management, and other helpful functions, would be one of the services provided. Yet while there are more than 100 U.S. mutual funds that offer asset allocation by investing in a mix of equity and fixed income securities, investors, for the most part, have chosen to perform that task themselves: of the $7.8 trillion invested in non-money market mutual funds, just $641 billion–8%–is held by such “asset allocation” funds, according to Investment Company Institute (ICI) figures.

Slowly, that is changing, after the stock market implosion of 2008 and early 2009 wiped out equity investors’ gains for the past decade or longer. Since September 2009, investors have pumped $18.9 billion into these funds, also known as “blended,” “hybrid,” or “balanced” funds, while domestic equity funds experienced net outflows of $43.9 billion over the same period.

To find the most attractive asset allocation funds, we screened for funds with Standard & Poor’s highest five star rank, and that also have at least $20 million in assets, are open to new investors, and have share classes for individual investors. We also chose to exclude all those that are simply “funds of funds,” since that would entail analyzing the appeal of the funds they owned as well as the fund itself. With the list narrowed to about 30 funds, we choose three funds that combined strong performance over the past 10 years with low costs, and chose one from each of three groups: growth-oriented funds that have 60% or more of their assets invested in equities, moderate funds that have a 40% to 60% equity allocation, and conservative funds with less than 40% of their holdings in equities.

Among growth-oriented funds, American Beacon Balanced (AABPX *****) combines strong long-term performance, moderate expenses, and a relatively large asset base of $842 million. The fund returned an average of 5.54% annually over the past 10 years compared with a peer average of 2%, according to Lipper data, and 7.78% since it opened for business in August 1994. It currently holds just shy of 60% of its asset in equities, an allocation that can vary between 50% and 70%, the fund says. About half of its fixed income holdings are corporate bonds. Its equity holdings are managed from a value perspective, as are as many asset allocation funds, with about 22% in the financial sector; JP Morgan Chase [JPM *****], Bank of America [BAC *****], and Wells Fargo [WFC ****] were its second-, third-, and fourth-largest holdings as of year-end 2009.

For funds with a moderate equity allocation, Greenspring Fund (GRSPX *****) can boast of outstanding long-term returns, though its costs are appreciably higher than the others we chose. The $528 million fund had 40% of its assets in equities at the end of January 2010, 26% in convertible bonds and 29% in corporate bonds, with the remainder in cash. Like the American Beacon fund, it is managed from a value perspective, setting its goal as “preservation of capital during difficult market conditions and achievement of strong gains during more favorable times.” Consistently strong performance is how the fund earns its keep: over the past 20 years (the fund opened in July 1983), it has returned an average of 8.66% annually, with a 10-year average annual return of 8.23% as of year-end 2009. Those returns have not dipped below 2.5% over the past one-, three-, five-, 10-, or 15-year periods as of year- end 2009. As of the end of January 2010, its top three equity holdings were j2 Global Communications [JCOM NR], PartnerRe [PRE ***], and Assurant [AIZ ****].

Investors in a conservative frame of mind might consider the Fidelity Asset Manager 20% (FASIX *****), a $2.6 billion fund which, as its name suggests, allocates a maximum of 20% of its assets to equities. In addition, it holds 50% of its assets in bonds, and the remaining 30% in short-term debt or money market securities. While such a low equity allocation may curb future returns over the long term, the fund’s past performance has been enviable, with an average annual return of 4.72% over the past 10 years as of Jan. 31, 2010, 4.3% over the past five-year period, and 2.27% in the past three years–a period, by the way, when many funds showed negative returns. The fund’s top 10 fixed income holdings are all U.S. Treasury or agency issues, while its top three equity holdings are Microsoft [MSFT ****], Apple [AAPL ****], and Google [GOOG ****].

(Note: the fund rankings in this article–from five star (best) to one star (worst)–are quantitatively derived from performance, holdings, risk, and expense analysis. The stock rankings, or STARS, using a scale of 5-STARS (strong buy) to 1-STARS (strong sell), are based on S&P equity analysts’ qualitative and fundamentally-driven outlook for the stock in the next 12 months. NR means not ranked.)

S&P Senior Financial Writer Vaughan Scully can be reached at [email protected]. Send him your ideas for mutual fund story topics.