Investing For Your Future
Monthly IFYF Investment Message
October 2004
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Asset allocation mutual funds are a "low maintenance" investment option popular with busy investors. What is an asset allocation fund? First, let's first define asset allocation, which is the process of distributing one's portfolio among various asset classes (e.g., stocks, bonds, and cash). For example, an investor might place 50% of his or her money in stocks, 30% in bonds, and 20% in cash assets such as money market funds and Treasury bills. Asset allocation funds include securities from all three asset classes in varying proportions.
Asset allocation funds have several advantages. First, like all mutual funds, there is professional management. Fund managers select the securities in the fund portfolio and monitor their performance on an ongoing basis. Another characteristic is above-average diversification derived from the combination of asset classes. Very often, when one type of asset (e.g., stock) is performing well, others (e.g., bonds) are not.
The performance of an asset allocation fund will reflect the weighted average of the portfolio asset classes. As a simple example, if 60% of the portfolio is in stock and 30% in bonds, and 10% in cash, and the three asset classes earn 10%, 6%, and 4%, respectively, the weighted average return would be 8.2% (.06 x 10% = 6 + .03 x 6 = 1.8 + .01 x 4 = .4).
A third advantage of asset allocation funds is their relatively low entry level. Instead of having to meet the minimum deposit amount for separate stock, bond, and money market funds, an investor needs only the minimum amount required for one mutual fund that contains all three asset classes.
Asset allocation funds also have several disadvantages. First, like all mutual funds, there are no guarantees you'll make money. If one or more of the asset classes perform poorly, this will be reflected in the net asset value (NAV), or price per share, of the fund. A second disadvantage is that, if an asset class does particularly well, only a portion of the portfolio will reflect this performance due to the diversification of the fund.
Many major mutual fund families have asset allocation funds. There are several different types. Lifestyle (a.k.a., life cycle) funds allow investors to select from among three or four portfolios (e.g., aggressive growth, growth, moderate growth, income) with different mixes of stocks, bonds, and cash planned to fit people at different stages of the life cycle or with different tolerances for risk. Two examples of lifestyle funds are Vanguard LifeStrategy funds and T.Rowe Price's Personal Strategy funds. Another option is a "fund of funds" (a mutual fund that invests in other mutual funds) which also provide broad diversification within a single mutual fund. Two relatively low-cost funds of funds are Vanguard STAR and T.Rowe Price Spectrum.
Another increasingly popular type of asset allocation fund is the target-date retirement fund. These are mutual funds with a future date in their title, such as the "Retirement 2025 Fund." Target-date retirement funds are generally packaged in five or ten year increments from 2005 through 2050. The fund invests in what it considers to be an appropriate asset mix for each target date and automatically adjusts the mix to a more conservative profile as shareholders get closer to retirement. Many major mutual fund companies, such as T. Rowe Price, Fidelity, and Vanguard offer funds of this type. The asset allocation weightings can vary among investment companies, however, so a careful reading of the prospectus for funds you are considering is in order.