August 2010 Mutual Fund Red Flags

Target-date funds have been under a good deal of scrutiny from regulators, investors, and the media over the past couple of years, much of it stemming from the poor performance of the so-called 2010 funds-- those intended for investors planning to retire around the year 2010--during the 2008-09 bear market. The category as a whole averaged around a negative 22% loss return in 2008, with the worst funds approaching losses of 40%. While some of these results can be attributed to high equity weightings, additional pain was inflicted in some cases by underperforming core bond funds.

For a number of the afflicted target-date series, those results precipitated a turn to a savior of sorts--Bill Gross and his PIMCO Total Return PTTDX strategy, which survived 2008 with flying colors and earned Gross the Morningstar Fixed-Income Manager of the Decade designation. After 2008, several target-date managers either initiated or significantly increased positions in Gross-managed investments.

And yet the turn toward this estimable core-bond fund raises some concerns. For one thing, there is an element of window-dressing to adding PIMCO Total Return to a portfolio after weak results. Certainly, it's hard to fault anyone for holding these funds, but their presence may paper over other weaknesses in a target-date fund's fixed-income lineup.

Moreover, investors may unknowingly be placing more assets in Gross' hands than they realize. As PIMCO Total Return is the largest mutual fund, it's likely that many target-date investors may already be exposed to Gross' strategy elsewhere in their portfolios. Even as astute a manager as Gross is not infallible; should one of his macro calls miss, or should the size of his assets under management eventually lead to underperformance, investors who are overexposed to PIMCO could pay a price.PAGEBREAK

ING Solutions 2015 ISOSX currently has one of the largest Gross-managed positions--13.5% as of March 31, 2010. This fund already held a substantial 6% stake in its ING-branded clone of the Gross strategy at the end of 2007. By the end of 2009, that position had nearly doubled to 12% of assets, as the target-date managers pulled assets from a troubled ING-run intermediate bond fund. ING does tinker with its portfolio, but the PIMCO stake seems stable for now.

A similar but even more dramatic shift took place at Principal Lifetime 2010 PTTIX. In 2007 and 2008, the fund had as much as one third of assets parked in Principal Mortgage & Securities, whose spreadoriented approach fared poorly during the financial crisis. Recognizing the bias in its bond portfolio, Principal hired PIMCO to subadvise a new offering, Principal Core Plus Bond PCBZX, which now soaks up about 12% of overall assets in the 2010 fund.

The Schwab Target series only began allowing third-party funds in 2009. Given the problems the firm has experienced with its Total Bond Market fund, a bottom-quintile performer over the trailing three, five, and 10 years, it's little wonder that the firm turned to PIMCO. Schwab began investing directly in PIMCO Total Return in mid-2009, and it currently has a 6% stake in the fund. Schwab's target-date funds remain a work in progress, so it's hard to know the long-term role for Gross in the series.

Finally, it's worth pointing out several firms whose close affiliations with PIMCO have led to hefty investments in the Total Return strategy. These include PIMCO RealRetirement 2010 (15%), Allianz Global Investment Solutions (15.5%), and Harbor Target Retirement 2010 (a whopping 36% in Harbor Bond). We don't see impending doom here, but it's worth tallying up your portfolio's overall exposure to PIMCO. Gross has made many bold calls over the years and most have paid off, but you wouldn't want a couple of wrong steps to seriously damage your portfolio. So, make sure you have some fixed-income holdings outside the PIMCO realm. Fidelity and Vanguard are among the better bond managers working outside Newport, Calif.

Josh Charlson is a mutual fund analyst with Morningstar.