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Outsourcing Asset Allocation

Thanks largely to advisors, dynamic funds of funds are taking their turn in the spotlight.

Laura Pavlenko Lutton, 12/03/2012

This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

T. Rowe Price Balanced RPBAX has the trappings of a vintage moderate-allocation offering. It’s a straightforward asset-allocation fund with a fairly static 60%/40% stock/bond mix. After growing quickly through the mid-1990s and then surging again in the early 2000s, its asset growth has stalled. In fact, the fund has lost about 10% of its assets to outflows since 2008, and Morningstar’s analysts stopped following the fund in 2011.

Interest has shifted elsewhere not because this fund is a dud. It sports a 4-star Morningstar rating, and its 10-year record is in the peer group’s top quintile. Even so, it looks a little pedestrian relative to more dynamic offerings that have been on the rise, like target-date funds with their 40-year glide paths and super-slick ETF managed portfolios. In an era when many financial advisors are outsourcing their investment selection, it appears that fancy funds of funds are sparkling.

Seeing the Roots
The concept of a fund of funds isn’t a new one. It’s been employed at T. Rowe Price Balanced and other asset-allocation funds for decades. But the idea of more-dramatically altering a fund’s asset allocation over time went mainstream in 2007 when the U.S. Department of Labor qualified target-date retirement funds as default investments in defined-contribution plans.

Since then, when employees enroll in a 401(k) plan and don’t select specific investments for their retirement savings, they most often end up in the target-date retirement fund whose target year falls closest to their 65th birthday. In the years leading up to that date, the fund’s asset allocation shifts, so it owns less equity and more fixed-income and cash investments. No need for the 401(k) participant—or an advisor— to rebalance the assets along the way. Instead, that task is delegated to the professional fund manager.

The concept of outsourcing one’s asset allocation is being popularized elsewhere, especially in 529 college savings plans. Since 529 plans began to blossom in the early 2000s, most have enhanced their age-based options. These investments are structured like a target-date retirement fund: College savers choose the 529 plan’s age-based option that corresponds with the child’s current age or their high-school graduation year. As the child nears the college enrollment year, 529’s age-based tracks typically move quickly into cash and bonds, to preserve the higher-ed nest egg.

Age-based tracks are understandably popular in 529 plans that are sold directly to college savers, who want to choose a “set it and forget it” investment. But as Kailin Liu points out in “Age-Based Options Take Over 529 Industry”, age-based tracks have been just as popular in 529 plans sold through advisors.

Amping Up the Complexity
As funds of funds with shifting asset alloca- tions have become more common, their insides are increasingly less so. The target-date retirement funds have been using their series as laboratories for new ideas in asset allocation, especially after the funds posted steep losses in 2008’s market slide. On average, target-date funds lost one fourth of their value that year, leading to broad criticism from regulators, elected officials, and retirement-plan participants alike.

Many series have since tweaked their asset allocations to include nontraditional asset classes that aim to diversify the series’ returns stream and produce better risk-adjusted returns. A Morningstar study in 2011 found that 11 of the industry’s largest series included diversifying asset classes such as commodities, natural-resources, energy, and precious- metals funds. For example, Vantagepoint Milestone, a series owned only by the public employees that Vantagepoint serves, includes a long-short fund. DWS LifeCompass’ ultra-diversification strategy includes a market-neutral strategy and dedicates assets to energy stocks through a sector ETF. And T. Rowe Price created T. Rowe Price Real Assets specifically for use in its target-date and 529 plans’ age-based options, illustrating how the firm’s asset allocators are driving an important part of the fund-development agenda at the staid firm.

Among the more-unusual approaches to asset allocation can be found in Invesco Balanced-Risk Retirement and PIMCO RealRetirement, both of which focus on generating real returns and limiting tail risk close to retirement. While the two series’ goals may be similar, they’re designed quite differently. The Invesco series uses a risk-parity approach, attempting to smooth out returns by equalizing the risk of equities, bonds, and commodities, using leverage in some areas. Meanwhile, the PIMCO series features diversifying funds such as PIMCO Real Return PRTNX and PIMCO Commodity Real Return Strategy PCRPX, along with an active hedging strategy.

Time will tell which approaches yield strong returns amid lower volatility. Interestingly, of 25 the target-date series that Morningstar has rated, DWS LifeCompass has been one of the worst performers, suggesting that the series’ ultra-diversification strategy has not been well-executed. Others that have been more successful on the performance front are JPMorgan SmartRetirement, American Century LIVESTRONG, and MFS Lifetime—all of which are run be experienced asset allocators who have included a decent stable of funds to employ in their series. Overall, they’ve been successful in recent years choosing the series’ underlying holds and getting some of the broader asset-allocation calls right.

It’s also worth noting that the target-date series with the best overall series rating from Morningstar’s analysts as of November is Vanguard Target Retirement, which runs a fully passive series and has done extensive research on portfolio diversification. The firm argues that adding in alternatives and other smaller asset classes won’t help returns over the long term because those investments can’t overcome their costs. Thus far, Vanguard has demonstrated it can more than keep up with complex designs, but indexing’s tailwind has been steady and strong in recent years.

Advisors Embrace ‘Solutions’
The rise of complex funds of funds certainly makes sense for individuals who arguably are less willing or able to combine an effective, well-diversified portfolio. But even professional investors—individual advisors and institutions— have shown that they have an appetite for these all-in-one investments. This hunger has grown since 2008’s downturn put big dents in clients’ portfolios and made many advisors fear for the viability of their practices.

The fund industry—especially at firms selling primarily through advisors—have been quick to launch what they call “solutions”—many of which are funds of funds designed to give client portfolios an all-weather feel. More than 400 share classes of funds of funds have been launched since 2008’s market dive. Take JPMorgan Diversified Real Return, which was launched in March 2011 and is run by the team behind the firm’s successful target-date series and other asset-allocation funds. Its fund-of-funds structure includes strategies with inflation-managed bonds, commodities, real estate, natural resources and a real-return objective. It has gathered $68 million of assets in its first 18 months, without a lengthy retail track record.

Though not technically a fund-of-funds solution, funds from Dimensional Fund Advisors are becoming more popular with advisors. DFA has an all-in business model where advisors exclusively use DFA funds in their clients’ portfolios. DFA has risen in assets to the fund industry’s top 10 as clients use the firm’s quantitatively driven funds to create customized fund-of-funds portfolios for clients.

What may be even more striking is the rise of ETF managed portfolios, which are similar in concept to open-end funds of funds, but often include tactical asset-allocation components. As Andrew Gogerty details in “ETF Managed Portfolios on the Rise”, these portfolios cover a host of strategies and have grown quickly—to nearly $50 billion of assets.

ETF managed portfolios have developed a following among advisors because they can be added to portfolios through separately managed accounts or unified managed accounts, which can be cheaper or more-flexible than traditional mutual funds. The most-established managers are Windhaven Investment Management and Cougar Global Investments, which together control about one fourth of the ETF-managed-portfolios industry. But many smaller players are benefitting from the enthusiasm for these flexible, fast-moving strategies.

Staying Power?
Expectations are high for fund-of-funds strategies, with both individuals and advisors. Studies of retirement-plan participants have indicated that many believe that their target-date retirement fund will support their retirement spending needs—regardless of how much they contribute to their 401(k) plan. That’s probably too good to be true, but advisors are increasingly finding a role for funds of funds in client portfolios. Whether the advisors are ultimately satisfied with the funds’ outcomes remains to be seen. As many fund firms (and, undoubtedly, advisors) have discovered, combining funds to produce a desired stream of returns is much more difficult than back-testing and logic would suggest. But the broad diversification goals behind funds of funds are sound and a step forward for investors.

Laura Pavlenko Lutton is an editorial director in Morningstar's fund research group. She would love to hear from you, but she can't give portfolio advice.

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