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The Professor’s Reading Room
By John Haslem

Domestic-hybrid mutual funds have received a great deal of attention and huge amounts of net new assets since the last market crash. William S. Rocco (2004) reported that moderate allocation funds rank first thus far in 2004, with $23 billion in net new assets. These fund types vary with respect to investment objective, active or index management, proportions of stocks and bonds, and mix of stock cap size/investment style and, therefore, risk.

There are several types of domestic-hybrid mutual funds that apply various stock/bond allocations in efforts to provide full diversification in one portfolio. These "one stop shopping" funds were initially designed to simplify decision making for long-term investors and pension plan participants. This design was considered appropriate if the benefits of risk-moderating bond allocations were to be fully realized. Later, the more established and successful of these funds were deemed appropriate as core elements of portfolios.

Domestic-hybrid mutual funds come in two basic forms: balanced funds and asset allocation funds . Each form focuses on a different approach to stock/bond allocation, and their histories precede their overall label as domestic-hybrid funds.

Balanced Funds

Balanced mutual funds are the original type of domestic-hybrid fund. These funds are actively managed and normally have relatively constant long-term stock/bond allocations, along with periodic portfolio rebalancing. The funds are thus designed for conservative investors with long-term investment horizons. Balanced fund allocations range in the order of 60/40 stock and high-quality bonds. But these allocations do vary by fund, and may be tilted by investment style based on broad market themes.

The Vanguard Wellesley Income Fund is an example of an actively managed balanced fund. The fund invests 60% to65% of its assets in investment-grade longer-term corporate bonds, U.S. Treasury and government agency bonds and mortgage-backed securities. The fund invests the remaining 40% to 35% of assets in stocks with histories or expectations of above-average dividends. While stock/bond allocations may vary with market expectations, bonds are expected to be at least 60% of the portfolio. The fund practices active security management, but its stated range of stock/bond allocations is very narrow.

Funds Of Funds

Funds of funds are balanced mutual funds that invest in the shares of other mutual funds. For example, the Vanguard Star Fund invests in funds that together comprise three asset classes: stocks, bonds and short-term securities. The fund is actively managed and invests 60% to 70% of assets in stock mutual funds, 20% to 30% in bond funds and 10% to 20% in money market funds. The fund currently holds ten actively managed funds in varying proportions: six domestic stock funds, two international stock funds and two bond funds.

Funds of funds that invest in mutual funds within their own fund families do not normally impose sales loads in addition to those of the funds in which they invest. For example, the T. Rowe Price Spectrum Growth Fund invests only in Price family funds and does not impose additional loads. But, funds that invest in funds in other fund families do impose additional loads. Investors should invest only in low-cost funds that do not impose additional loads. The lowest-cost funds of funds normally hold low-expense index funds in their own fund families. They may also hold institutional funds that cater to large investors and have even lower expenses.

Asset Allocation Funds

Early asset allocation funds normally employed active (tactical) asset allocation, with changes in security allocations dictated by short-term market events and expectations. The popularity of these funds may be traced to the 1987 market crash, and again to more recent crashes that caught portfolio managers unaware. The risk limitations of asset allocation funds are normally defined with respect to fund objectives, such as permissible allocations of stocks/bonds, domestic/international stocks, small-cap/large-cap stocks and high/low bond quality.

The Vanguard Asset Allocation Fund is an example of an actively managed tactical asset allocation fund. The fund invests in three asset classes: stocks, bonds and short-term securities. The fund may invest up to 100% of its portfolio in any one of the three asset classes. The proportions of the classes change with market events and expectations. Advocates of tactical asset allocation funds consider this to be more a more sophisticated strategy than plain-wrapper market timing. But regardless of the labels attached, these funds practice market timing.

To determine the effectiveness of market timing, mutual funds and portfolio manager David Dreman (1998) measured the performance of tactical asset allocation funds. The 1985-1997 performance of 185 tactical asset allocation funds was compared both to buy-and-hold strategies, represented by an index, and to equity funds. This bull market period included two market declines, which makes it ideal for testing fund ability to time the market.

The results? Tactical asset allocation funds performed poorly over this period. The S&P 500 Index increased by 734%, average equity funds increased by 598%, but tactical asset allocation funds increased by just 384%. Dreman concludes in no uncertain terms that "(t)actical asset allocation has obviously not set the world on fire. In fact, it's downright awful, even in the periods where asset allocators claimed they swept the field. The prosecution rests."

Life-Stage Funds

Life-stage funds (also called lifecycle and lifestyle funds ) are more recent versions of asset allocation funds. These funds invest in individual securities while others are funds of funds. Most life-stage funds maintain fairly stable asset allocations, but others less so.

Olivia Barbee (1998) noted that life-stage funds were initially formed for 401(k) pension plans, to provide participants with easy asset allocation and diversification. Some pension plans even offer tailor-made funds of funds. For example, one plan allows participants to choose from eight different life-stage funds, each of which contains different allocations of five managed asset pools. But, while Lynne Brenner (1999) reported an 83% increase in pension plan offerings of life-stage funds, their assets have not increased significantly .

Barbee determined that life-stage mutual funds are useful for investors who want to invest a large sum of money quickly and with diversification, or for specific future needs. However, these funds lack a relatively long performance history, which makes it more difficult to analyze competing types of funds. Also, differences in fund terminology and portfolio asset classes and allocations make it difficult to judge relative risks.

Barbee concluded that '(l)ifecycle funds may have all the limitations of prepackaged goods, but they're nonetheless a useful proxy for the real thing.' In this case, the "thing" missing is a personalized portfolio.

Alice Lowenstein (1994) described life-stage funds as distinguished by use of asset allocation for financial planning, rather than only as investment objectives. Fund portfolios are designed to match investor investment horizons and risk tolerances as determined by investor questionnaires. This use of personal finance wrappers usually distinguishes life-stage funds from traditional asset allocation funds.

Life-stage mutual funds normally have more narrowly defined investment objectives than asset allocation funds. For example, the four Vanguard LifeStrategy funds are funds of funds that invest, according to fixed formulas, in four to five Vanguard - primarily index - funds. For example, the Vanguard Life-Strategy Conservative Growth Fund seeks to provide current income with low to moderate growth in value. A conservative 40/60 stock/bond allocation is normally maintained. The fund invests in the actively managed Vanguard Asset Allocation Fund (25%), Total Stock Market Index Fund (20%), Total International Stock Index Fund (5%), Total Bond Market Index Fund (30%) and the actively managed Short-Term Corporate Bond Fund (20%).

In contrast, the Vanguard Life-Strategy Growth Fund seeks to provide growth in value with some current income. An aggressive 80/20 stock/bond allocation is normally maintained. The fund invests in the Vanguard Asset Allocation Fund (25%), Total Stock Market Index Fund (50%), Total Bond Market Index Fund (15%) and the Total Bond Market Index Fund (10%).

However, consistent with earlier asset allocation funds, there are life-stage funds that practice tactical asset allocation. In contrast to the Vanguard LifeStrategy Funds, these funds apply market timing within broad ranges of defined security classes. For example, the Fidelity Asset Manager Growth Fund has a risk-neutral mix of 70% equities, 25% bonds and 5% cash assets. However, the fund may invest from 50% to 100% of its assets in stocks and up to 50% in bonds and in money market securities. Broad ranges in asset allocations provide broad risk/return parameters, which may be inappropriate for conservative long-term investors.

In contrast to balanced funds, there are life-stage mutual funds that hold security classes within wider ranges of investment quality. These holdings might include small-cap stocks international stocks, and; high-yield bonds also are often held . The high-yield bonds are not investment grade, but as portfolio diversifiers they are not inconsistent with long-term portfolios.

Target Maturity Funds

Alice Lowenstein (1994) also described target maturity funds as a new model of life-stage mutual funds. These funds are designed with particular maturity dates, which allow investors to select funds that match their investment horizons, such as retirement. Fund security holdings and asset class allocations become more conservative as the stated target dates approach ¾ stock allocations are reduced and bond and money market fund allocations increased.

For example, the Wells Fargo Stagecoach LifePath funds ask investors to select the particular fund that matures closest to the date when they will need cash. The Wells Fargo funds began with LifePath 2000. Each fund continues with a more distant ten-year interval target date, such as LifePath 2040. These conservative maturity portfolios are not always best for retirement. Life expectancy at normal retirement age calls for long-term strategies that provide growth to offset inflation.

Strategic-Income Bond Funds

More recently, life-stage mutual funds have offered so-called strategic-income bond funds. These bond funds are based on the low correlations among the returns on U.S. Treasury bonds, international government bonds and high-yield (junk) bonds. These funds provide an easy way to diversify risk in portfolio bond allocations. For example, Lori Lucas (1992) noted that the T. Rowe Price Spectrum Income Fund has less risk than any of its component bond classes. This reduced risk is the benefit of proper diversification. T. Rowe Price provides another example of diversification in its GNMA Fund and High-Yield Bond Fund. The returns on these funds are not highly correlated, making them good joint diversifiers in bond portfolios.

All-Weather Portfolios: Traditional And Later

All-weather portfolios are known for their simplicity of construction, yet they appear to be one of the most enduring types of portfolios. Gerald Perritt has been credited for creating the first such portfolio, which has equal proportions of seven asset classes, including gold. A later version has five asset classes ¾ stocks, bonds, cash, real estate and gold. This later portfolio outperformed the S&P 500 Index, with less risk, for the years 1968-1984.

Scott Burns ()(1997) reported that the most recent Perritt portfolio includes equal proportions of just four asset classes: cash, stocks, bonds and gold. Real estate was omitted because it was decided that most investors already own too much personal real estate. International stocks were omitted because about 25% of the S&P 500's operating earnings come from overseas. Also, cash assets would be better invested in a liquid "cash bucket" than in the investment portfolio.

Burns adapted Perritt's portfolio to his own Couch Potato Portfolio designed for 'the inactive investor (who) responds to the market by ignoring it." The portfolio consists of equal allocations of the Vanguard 500 Index Fund and Vanguard Total Bond Market Index Fund, which are rebalanced periodically.

At year-end 1996, the Couch Potato Portfolio had annualized returns of 12% over ten years, and 14% over 15 years. The S&P 500 Index had slightly higher annualized returns of 15% and 17%, respectively, but with more risk. Moreover, the portfolio outperformed growth and income funds, balanced funds, asset allocation funds, U.S. Treasury bond funds and high-quality corporate bond funds. Consistent with earlier findings, portfolios do not have to be complex to do well .

The "all-weather" label was later applied to mutual funds that apply various strategies that seek to do relatively well in both good and bad markets. Such funds include both conservative asset allocation and balanced funds, the two basic types of domestic-hybrid funds discussed above. Morningstar, on the other hand, now employs the categories of Conservative Allocation and Moderate Allocation.

Catherine Hickey (2000) reports that the average all-weather fund is 40% invested in bonds, but there are funds that invest as much as 70% in bonds. All-weather funds are also known to employ several other diverse strategies: focus on value stocks, broad stock market diversification, herding on the S&P 500 Index and focusing on tax efficiency.

Hickey's favorite all-weather funds include several domestic-equity funds: Vanguard Wellesley Income Fund, Vanguard Asset Allocation Fund and Vanguard Tax-Managed Balanced Fund. The Asset Allocation Fund is a tactical asset allocation fund, the Tax-Managed Balanced Fund is, in part, an actively managed balanced fund, and the Wellesley Income Fund is an actively managed balanced fund.

Conclusion

Careful attention to the prospectus and Morningstar are essential to making solid fund selections within and among the types of domestic-hybrid funds. If used as an element in a portfolio, the fund must fit in with the allocation design of the total portfolio.

Bibliography

Barbee, Olivia, 1998, Focus on: Lifecycle Funds, Morningstar Investor , February, 17.

Brenner, Lynne, 1999, A Fund for All Ages, Bloomberg Personal Finance , December ( http://www.bloomberg.com)/.

Burns, Scott, 1997, The Joy of Doing Nothing, Worth , March, 121-122.

Dreman, David, 1998, Contrarian Investment Strategies: The Next Generation ¾ Beating the Market by Going Against the Crowd ( New York : Simon & Schuster).

Hickey, Catherine, 2000, Unearthing All-Weather Domestic Hybrid Funds, Morningstar FundInvestor , March, 1-3.

Lowenstein, Alice, 1994, Life-Stage Programs Popular, but of Limited Use, Morningstar Five Star Investor , November, 14-15.

Lucas, Lori, 1992, Promises, Promises, Morningstar Mutual Funds , November 2.

Rocco, William S., 2004, Choose Your All-Weather Fund with Care, Morningstar.com , June 1.

Note: See the individual Vanguard and Price fund syllabuses for further information on the funds noted.
 

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