Beware of Lead Balloons

Allocation funds are typically used as a one-stop shop or as a core holding for an investor's portfolio. Investors holding allocation funds have come to expect the fund's stock sleeve to be the main driver of returns (for better or worse) and for the fund's fixed-income sleeve to provide some ballast when the going gets rough. We wouldn't expect any allocation fund to have been immune from the market's recent turmoil, with Morningstar's stock fund categories down 14% to 60% over the trailing 12 months through March, and all but three of our fixed-income fund categories are also in the red.

Even so, the dispersion of recent results in our allocation fund categories is eye-opening. The average conservative-allocation fund has lost 19% over the trailing 12-month period, with 53 percentage points separating the best- and worst-performing funds. A 28% loss marks the average among moderate-allocation funds, with a whopping 68 percentage points dividing the winners and losers. World-allocation funds have posted an average loss of 29%, with results spanning a gap of 54 percentage points. In each category, the gap between the penthouse and the basement is more than three times each category's range of returns over the trailing 10-year period.

Investors may have overlooked the fixed-income sleeves of their allocation funds, but we're disappointed at the lead balloons in some allocation managers' fixed-income portfolios. Some missteps stem from relatively straightforward sources. Meaningful bets on nongovernment mortgage-backed securities have taken a toll on funds such as  UBS Global Allocation (BPGLX). Big stakes of beaten-down high-yield corporate bonds are weighing on the performance of the income-oriented funds in the conservative- and moderate-allocation categories, such as Evergreen Diversified Income Builder (EKSAX). Those stumbles are at least understandable when considering the cash bonds their managers bought.

What You (Don't) See Is What You Get
The market's recent turmoil has also shone a harsh light on fixed-income strategies several degrees more opaque and more risky than investors would have expected a decade ago. My colleague Eric Jacobson detailed the use of economic leverage in bond funds in his recent Fund Spy entitled, "Bond Funds Swimming Naked," but the general idea is as follows. Some bond managers used derivatives such as credit default swaps to gain market exposure. That strategy usually requires only a small initial outlay of assets, so managers typically park the assets backing those positions in securities that they view as cash equivalents or collateral. The resulting mix can result in greater market exposure than management could gain through cash bonds alone, and what each firm considers a cash equivalent varies widely. Some so-called equivalents have borne much more credit risk than management anticipated. Some such as asset-backed securities or floating-rate nongovernment mortgage-backed securities have remained difficult to trade for most of the past year.

The combination of derivatives and cash equivalents has brought unanticipated and in some cases disastrous results. At  AIM Basic Balanced , the fixed-income team's decision to use derivatives to gain exposure to battered financial firms such as Lehman Brothers and mortgage insurer MBIA contributed to the fund's 40% loss. The team backing  Oppenheimer Core Bond (OPIGX) and  Oppenheimer Champion Income  made aggressive derivatives-based bets on a wider swath of corporate issuers and nongovernment commercial mortgage-backed securities, which have since decimated those funds. That pain spread into the bond sleeves of allocation offerings such as  Oppenheimer Capital Income  and Oppenheimer Portfolio Series Conservative (OACIX), which have suffered bottom-decile losses of 38% and 39%, respectively.

A version of a derivatives/cash equivalents strategy has also burned the venerable Grantham, Mayo & Van Otterloo, which subadvises  Evergreen Asset Allocation (EAAFX). GMO has gained most of its fixed-income market exposure through derivatives since 1993 and has invested its cash collateral in high-quality asset-backed securities. When the asset-backed market collapsed in late 2007 and early 2008, GMO was forced to write down the value of those securities. The Evergreen fund invests in several of the affected GMO bond funds, so its portfolio had roughly 26% of assets stashed in difficult-to-trade asset-backed securities lately. We're concerned that stake could limit the fund's flexibility to take advantage of opportunities or continue to weigh on the fund's performance if management is forced to sell those securities to meet investor redemptions. GMO has since conceded that its strategy is no longer viable, and because its ability to employ a new cash-bond strategy is unproven, we're steering investors away from the fund.

Investors Have Known Quantities to Choose From
It can be difficult to sift through funds' financial statements to determine the ultimate risks of funds' fixed-income strategies. Typically, derivatives positions are listed toward the bottom of the financial statements, sometimes in the footnotes following the fund's list of investments. Yet a glimpse of a long list of swaps, options, futures, or forwards in the financial statements is a worthy reason for a conversation with your advisor or a follow-up call to the fund company. Another red flag is a big difference between the line items named Total Investments and Total Net Assets, because it can indicate the use of economic leverage in the portfolio. Morningstar's fund analysts look through the filings for such red flags and point them out in our fund analyses.

Some firms, such as PIMCO, have proved their ability to use derivatives/cash collateral strategies safely and effectively. Yet investors spooked by the notion of hidden fixed-income risks in their allocation funds can certainly find more straightforward options. The conservative  Vanguard Wellesley Income (VWINX) is subadvised by top-flight Wellington Asset Management, and its fixed-income portfolio consists exclusively of investment-grade cash bonds. In the moderate-allocation category,  American Funds American Balanced (ABALX) also sports a plain-vanilla, cash-bond portfolio with only a sliver of assets stashed in high-yield bonds. Investors seeking a world-allocation fund should check out  BlackRock Global Allocation (MDLOX). That fund's management is likely to invest in a range of fixed-income securities and a dose of derivatives, but we're confident in its ability to employ its strategy successfully.