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Should You Allocate to Allocation Funds?

Tired of rebalancing your portfolios? Consider allocation funds. 

Cara Esser, 08/09/2013

As investors grow weary of managing not only individual fund selection but also allocation decisions, some have turned to allocation funds to ease the burden. In the mutual fund space, some of the most popular and well-known allocation funds are target-date mutual funds. These days, many 401(k) plans include target-date funds, allowing investors to simply choose their expected retirement date and let the funds' managers do the rest (this usually means following a preset "glide path" that places more emphasis on bonds as the retirement date approaches). If you're interested in target-date mutual funds, you can read the latest Morningstar research on them here.

An alternative to target-date offerings are funds that hold both equity and fixed-income securities, usually within specified bands, moving into and out of asset classes more fluidly than a predetermined glide path. Within allocation funds, investors will find a variety of "neutral allocations" (a starting point for allocating to equity versus fixed-income instruments) and strategies. Some will be tactical, others will follow a more static allocation--for example, 70% to equity and 30% to fixed-income, with little deviation during various market cycles.

Morningstar identifies three categories of domestic allocation funds based on historical portfolio weightings between equities and fixed-income instruments. (World-allocation funds fall into their own category, and it's within this category that we've seen the broadest range of strategies and asset mixes. For that reason, we do not include it in this discussion.) Conservative-allocation funds tend to place more emphasis on fixed income and less on equities, typically investing 20%-50% in equities and 50%-80% in bonds and related securities. Moderate-allocation funds are more slanted toward stocks but generally keep these allocations to 50%-70%, with the remainder in fixed income. Finally, Aggressive-allocation funds are the most heavily invested in equities, generally allocating 70%-90% of the portfolio to them. Keep in mind that funds and managers can allocate to various sectors and industries within equities and fixed income. And, in terms of fixed-income securities, allocations may be to any number of income-generating securities including high-yield or investment-grade corporate bonds, convertible securities, preferred stock, government bonds, or mortgage- or asset-backed bonds, to name a few.

That asset mix can materially affect a fund's risk/reward profile and will affect what investors can reasonably expect from a fund's performance. As a result, before buying a fund, it's important to understand which securities the fund has held in the past and whether the manager moves within sectors frequently, chooses to remain invested in a certain type of fixed-income security, or prefers a certain sector such as financials or utilities. Knowing those characteristics increases the chance of investors using an allocation effectively.

Returns and Risk
While the Morningstar Categories refer to mutual funds, closed-end funds, and exchange-traded funds, Table 1 below highlights the 23 domestic allocation funds within the CEF universe with a least a one-year track record. On a total-return basis, many of the funds have fared well over the latest three-year period and nearly all have positive annualized returns over the five-year period ending Aug. 2, 2013. Note that many of the funds on the list use leverage, magnifying returns.

Compared with SPDR S&P 500 SPY all have underperformed over the three-year period, but five-year numbers (which include 2008) look stronger likely because of the allocation funds' bond holdings, which generally held up better during the crash than equities. Due to that defensive aspect and the recent years' bull market in bonds, it should not surprise investors that the average conservative-allocation fund has outpaced the average moderate- and aggressive-allocation fund over the past five years (a category average gain of 10% versus 8% and 6%). But, as the equity market has remained strong over the past year, the average aggressive-allocation fund far outpaced the average conservative- or moderate-allocation fund (27% versus 13% and 14%).

Despite variations in overall strategy and allocation, essentially all of the funds on the list in Table 1 are trading at discounts, most of them historically wide discounts. Of note is the highest-distributing fund on the list, Cornerstone Progressive Return CFP, which is selling at a 15% premium. On its face, Cornerstone Progressive Return doesn't look terrible, but a deeper look shows a fund that has many red flags. First, it is a serial distributor of destructive return of capital (it pays 25% of net asset value each year), which is particularly worrisome because of the fund's persistent premium pricing (return of capital reinvested at a discount to NAV can actually be beneficial to long-term shareholder value). The fund tends to hold most of its assets in other CEFs and had a relatively high expense ratio (1.34%) in the latest fiscal year. We've written numerous articles about our distaste for funds managed by Cornerstone Advisors. Persistent, unwarranted premiums and dubious rights offerings make this fund a poor choice for investors. For investors interested in a fund that holds other CEFs, there are cheaper ETFs to choose from (notably PowerShares CEF Income PCEF) and better-performing mutual funds, though the best-performing mutual fund, RiverNorth Core Opportunity RNCOX, is closed to new investors. And, though performance is not as impressive, Cohen & Steers Closed-End Opportunity FOF is a CEF of CEFs, holding a mix of bond and equity funds.

Cara Esser is a closed-end fund analyst at Morningstar.

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