Excessive focus on style or geographic allocation can be limiting.
Many financial advisors consider asset allocation one of their main contributions to their clients' success. And they often extend that idea to include allocation within asset classes. In the aftermath of the global financial crisis of 2007-08 and the eurozone-fueled upheavals of 2011, diversification is viewed as even more critical than before. Thus, many advisors will recommend owning a growth fund to balance a value fund, emerging-markets funds in addition to those targeting the U.S. and developed international markets, and may also include a variety of other asset classes besides stocks and bonds.
Diversifying certainly has merit. Over the past decade and more, we've heard too many stories of investors who had the bulk of their retirement funds in company stock that became worthless, or who had loaded up on aggressive equity funds with little attention paid to anything that might hold up better when stock markets declined. Including different types of stock and bond funds, and perhaps other assets as well, can--at least in theory--help investors avoid panic and stick it out through rough patches, because at least a few of these funds should hold up decently well even if others are struggling.
Some advisors take this approach to the furthest extent. They buy only mutual funds or exchange-traded funds that restrict themselves to very specific, and sometimes very narrow, mandates. Along with the advantages, though, there can be costs to taking this strategy that far.
People who invest this way have certain advantages. They know how much of their assets or their clients' portfolios is devoted to bonds, stocks, or other asset classes at any particular time. They also know the percentages of assets invested in U.S. versus foreign holdings, how much is in emerging markets, and even how much of the portfolio falls into specific sections of the Morningstar Style Box, such as large growth or small value.
With asset-allocation and style decisions taken out of the hands of a portfolio manager, advisors and investors can decide for themselves whether to maintain or change those allocations, and then monitor them to ensure they're getting exactly, or almost exactly, the allocations and style diversification that they want.
What This Approach Gives Up
In exchange for that certainty, those who take this route do risk missing out. There are many funds, both active and passive, that don't limit themselves to owning just one type of asset, or don't fit neatly and consistently into one portion of the style box, and yet are worthy of consideration.
These include the most wide-ranging, "go-anywhere" funds. But far more numerous are the many less-adventurous funds that happen to, say, occasionally buy some high-dividend stocks along with bonds to attain income, or whose portfolio simply moves from one side of a style-box border to another at times, depending on where the manager finds the most attractive opportunities.
One can build a reasonable and rewarding portfolio without looking at any of these choices, but including them provides a broader canvas from which to choose.
Where Flexibility Seems to Turn Buyers Away
An aversion to these types of funds might account for the difficulty Columbia Acorn International Select LAFAX has had in attracting assets. In general, this is a mid-cap growth fund, but it has a fairly flexible approach. As a result, the fund's portfolio currently lies right on the intersection between four sections of the style box: large blend, large growth, mid-blend, and mid-growth. Over the past decade, its average market capitalization often has placed it directly on, or just below, the large-cap border.
The fund's returns don't stand out at first glance, because its outperformance during the financial crisis from late 2007 to early 2009 has fallen out of the five-year ranking. But since its current manager took over the lead role in 2005 it has a strong record. Yet it has only $345 million in assets.
It's quite possible a key reason is that it doesn't fit smoothly into an allocation slot. Sibling Columbia Acorn International LAIAX has a slightly worse five-year record but has maintained a much more consistent placement in the middle of the mid-growth section of the style box, and it has amassed more than $8 billion in assets.
Another fund that could be suffering from this issue is Polaris Global Value PGVFX. While its 10-year return is so-so, its five- and 15-year figures each top about 90% of the world-stock category, and its three-year return beats nearly all of them. The same manager who racked up that long record remains in charge, using the same strategy. Yet the fund has only $279 million in assets.
One reason could be that Polaris is not a well-known firm. But neither is Pear Tree (once known as Quant, and not broadly familiar under that name either). Yet Pear Tree Polaris Foreign Value QFVOX, which is subadvised by Polaris and is essentially the same fund without the U.S. holdings, has $1.6 billion in assets. Both funds have impressive long-term records under the same manager. But even though the Pear Tree fund has a much higher expense ratio, it has more than 5 times the assets of its global version.
It's likely that one explanation for this discrepancy is that the Pear Tree version is more easily used by investors who want to make their own allocation decisions between their U.S. and international weightings. With Polaris Global Value, the manager decides which markets receive the assets.
A Hybrid Approach
There's nothing wrong with investing with allocation in mind, choosing funds that stay firmly in their section of the style box, or that restrict themselves to either U.S. or foreign markets, or to emerging markets, or to a certain sector or region. However, investors who limit themselves to only those choices, who place off-limits any fund that varies even a little from that template, can cut themselves off from some very worthy options.
With that in mind, some readers have told us they will use both types of funds. They like having much of their money dedicated to specific asset classes or areas of the market in amounts that they alone control. But they'll also allot some money to more-adventurous managers who have shown their ability to find the best opportunities if given the leeway to drift out of a section of the style box or to vary geographic weightings depending on the circumstances. Most such managers are not making market or sector calls; they're simply buying what seems to make the most sense at the time and paying less attention to where that places their overall portfolio weightings.
Note that I'm not referring here to the genre of funds loosely known as alternatives that has achieved much popularity lately. Many of these have short track records and high expenses. This column is referring to more-traditional funds that simply don't have strictly enforced mandates but that do boast the always-helpful traits of experienced management with an impressive record, sound strategy, and reasonable expenses.
Being open to both narrowly focused funds and those that can stray when opportunities arise seems to give investors the best chance to succeed over time.