Lessons from Fidelity's Freedom Funds

The Great Recession may have sullied America's love affair with the mall, but I doubt it will have the power to keep my mother away from it. That's despite her filled-to-the-brim closets, which are stuffed with items worn once or not at all--much to her husband's dismay. She might blame the weather for her sprawling wardrobe. After all, Chicagoans need both breezy T-shirts and heavy sweaters, and given their city's notoriously fickle climate, it's possible they'll wear both on the same day. But mom has three green T-shirts and four black sweaters, one not all that different from another. Her husband wonders why one of each wouldn't suffice.

Fidelity's Freedom Funds suffer from the same problem as my mom's closet. The funds, designed as one-stop retirement savings vehicles, spread their assets across a broad basket of underlying Fidelity funds--21 in all--with their mix of stocks, bonds, and cash becoming more conservative as shareholders near their anticipated retirement date. They invest in so many underlying funds for much the same reason Chicagoans own both T-shirts and sweaters. The market is as prone to extremes as the Windy City's climate, and investors should have diverse closets to weather different climates. But just as my mother could easily get by without four black sweaters, the Freedom Funds don't need three large-blend funds or two large-growth funds covering a lot of the same ground. To mom's credit, her sweaters are usually from fine stores and are well-made. In many instances, however, the Freedom Funds are stocked with less-than-stellar merchandise.

The point of this piece isn't to address whether I consider Fidelity Freedom Funds worthwhile investments. I think they're decent enough for hands-off investors with limited options in their retirement plans. Many of you may have a more active style to managing your portfolios, so a set-it-and-forget-it offering probably won't have much appeal anyhow. That doesn't mean you can't learn from them, though. The funds' glide paths--the pace at which they transition from a more aggressive asset allocation to a more conservative one--are rooted in more than a decade of research. Fidelity launched its first batch of Freedom Funds in 1996, long before most other fund companies unveiled their own target-date lineups. Despite their thoughtfully conceived glide paths, though, the portfolios themselves are mostly a lesson in what investors shouldn't do on their own.

Gliding to Retirement
As investors, most of us probably spend too much time thinking about the quality of our investments and not enough about asset allocation. Depending on whom you listen to, asset allocation--how you divvy up your portfolio among stocks, bonds, and other asset classes--explains most of, nearly all, or all of investors' long-term returns. The problem, of course, is determining the right asset allocation to begin with. Some approaches rely on different asset classes' historical volatility to calculate the ideal balance between risk and return. Others turn to probability statistics instead, running potential portfolios through thousands of possible return scenarios to come up with an asset mix to minimize the risk of outliving your assets or suffering a catastrophic loss when you can least afford it. For what it's worth, Fidelity has relied more on the latter approach.

Of course, what looks good on paper can fail in reality. So in constructing the Freedom Funds' glide paths, Fidelity studied investor behavior alongside historical asset class returns. Computer models might suggest the perfect numbers-based outcome, but if the resultant asset mix leads to a lot of short-term volatility, skittish investors may jump ship from the funds at the first sign of trouble, sabotaging their own long-term returns in the process. That helps explain why the Freedom Funds' glide paths are a bit more conservative than many competitors'.

As stocks rallied in the mid-2000s, a number of Fidelity's rivals launched target-date lineups with more equity-heavy asset allocations. T. Rowe Price, for example, took a more aggressive approach, arguing that without the growth potential that stocks provide, investors' nest eggs might not be big enough to accommodate their ever-lengthening life spans. On the same grounds, Vanguard boosted its target-date funds' equity stakes in 2006, though not as aggressively. Fidelity responded to longevity risk more subtly. It extended the length of the time it takes investors to move from their retirement date to the most fixed-income heavy offering in the Freedom lineup, Fidelity Freedom Income, from 10 to roughly 15 years. Once investors reach this final phase, the allocation is conservative, with stocks accounting for just 20% of the Income fund. Fidelity's research indicates investors spend more in retirement than commonly thought, so it's opted for a low-risk approach in investors' later years. Unlike some of its peers, Freedom Income doesn't have much in the way of high-yield bond exposure. And to avoid subjecting retirees to currency risk, the fund doesn't invest in foreign funds at all.

I'd interpret Fidelity's glide path (or anyone else's, for that matter) as a guideline, not holy writ. By their nature, target-date funds are one-size-fits-all investments, so their glide paths or asset allocations may not match your own risk tolerance or financial situation. If you're a more-cautious investor, Fidelity's relatively conservative asset allocation might suit you. But if you can stomach more risk, or if you can think you'll be able to rely on an income source outside of your investments in retirement, a more aggressive approach, such as Vanguard's or T. Rowe Price's, may better suit you. Figure 1 depicts Fidelity's glide path. (Morningstar.com Premium Members can peek at the glide paths of the 20 largest target-date providers, including  Vanguard and  T. Rowe Price, whose glide paths favor equities more heavily.)

Too Many Cooks Spoil the Broth
The Freedom Fund portfolios themselves leave plenty to be desired. Just as my mom could stand to clean out her closet, the funds could stand to have many fewer underlying investments. Fidelity defends the sprawling portfolios on diversification grounds. What undermines this argument is that so many of the funds invest in the same stocks.

Take the Freedom Funds' two large-value holdings,  Fidelity Equity-Income (FEQIX) and  Fidelity Large Cap Value (FSLVX). The offerings aren't clones of each other, but because they share a similar value discipline, about 40% of their portfolios are held in common with one another. If that's not enough, the Freedom Funds' three blend holdings, such as Fidelity 100 Index, own a lot of the same stocks as their value and growth counterparts. Half of the 100 Index's holdings are in Equity-Income, for instance, and nearly 40% are in  Fidelity Blue Chip Growth (FBGRX). Figure 2 maps out each of the Freedom Funds' domestic holdings on the grid of the Morningstar Style Box, depicting each holding's footprint--or Ownership Zone. With so many overlapping circles, the graphic is messy enough to nearly make my eyes bleed.

It doesn't help matters that the quality of the Freedom Funds' underlying holdings is mixed. Many of its equity fund holdings, like Fidelity Blue Chip Growth, are run by less-proven managers. True, some of them are run by veteran investors, such as Stephen Peterson, manager of serviceable but bland Fidelity Equity-Income, and Steve Wymer, the talented skipper of  Fidelity Growth Company (FDGRX). But the lineup excludes some of Fidelity's best managers. You won't see  Fidelity Low-Priced Stock's (FLPSX) Joel Tillinghast or  Fidelity Contrafund's (FCNTX) Will Danoff. If you followed the Freedom Funds' recipe too closely, you'd end up with a bloated portfolio missing some of Fidelity's best funds.

As I've written before, the Freedom Funds' design could use some more art and less science. Their portfolios were built using quantitative models designed to minimize the risk of underperformance. But the level of duplication in the underlying holdings could lead the funds to spread out beyond the point of diminishing returns. Fidelity's model also doesn't accommodate eclecticism. When I visited Fidelity last year, asset-allocation chief Ren Cheng told me Contrafund isn't included in the Freedom Funds because Will Danoff's go-anywhere style makes it a harder fit.

Your portfolio may need the same sort of housecleaning as the Freedom Funds. Like many of our closets, investment portfolios, too, often become cluttered with stocks or funds that have outlived their usefulness. If you were to clean out your closet, you'd have to first take stock of what you have before deciding what you get rid of. That's why I'd suggest loading your portfolio on Morningstar.com if you haven't already. Even if you're not a Premium Member, you can use the Instant X-Ray tool. The tool looks at your portfolio in its totality and will help you spot overlap issues, along with other potential problem spots. You can then weed out the lesser funds and use the X-Ray to make sure what's remaining still leaves you adequately diversified.