Benz: 7 Fund Favorites for the More Aggressive Retiree

Note: This video is being re-featured as part of Morningstar's October 2014 5 Keys to Retirement Investing special report. This video originally appeared in August 2014.

Jason Stipp: I'm Jason Stipp for Morningstar. Last week, our director of personal finance, Christine Benz, offered some of her favorite funds for more conservative retired investors. But what about those who want to take a somewhat more aggressive stance? She has a few ideas for you as well, and she is here to share those today.

Christine, thanks for joining me.

Christine Benz: Jason, it's great to be here.

Stipp: First of all, when might an investor entering retirement want to take a more aggressive stance? What are some potential reasons for that?

Benz: I think it's really important to make sure that you're not mixing up risk tolerance with risk capacity. So, you might feel like you have a high risk tolerance, you feel like you can handle more volatility and risk, but you want to be sure that you can literally handle that volatility and risk as well. So, if you lose money with some of your aggressive holdings that it won't force you to change your standard of living or change your spending habits.

People with higher risk capacities might have a lot of income coming in the door during retirement from nonportfolio sources. They might have, for example, a pension that is supplying a lot of their income. They really don't need to use their portfolio very aggressively. They don't need to spend it down very aggressively. They can afford to take more risk with their portfolio. So, I think you want to make sure that you are distinguishing between risk tolerance and risk capacity.

It's also true for people who are younger retirees--people who are, say, 60 when they retire. They absolutely do need to have a higher-risk portfolio because they need that portfolio to last them a longer period of time than the person who is retiring in their late 60s. So, it's important to make sure that you have those concepts straight in your mind.

Stipp: What if I feel like I haven't saved enough for retirement? Is that a reason for me to be more aggressive in my portfolio?

Benz: Possibly a little bit. I think that you can tweak around the margins. What you don't want to do is be dramatically more aggressive. So, if you're looking at a lot of target allocations for people in your age band and they're pointing to maybe having a 50% equity/50% bond portfolio, you absolutely don't want to shift 80% into equities. That's going to leave you with a too aggressive portfolio. But you definitely want to look at your own spending situation and use that to help drive the asset allocation of the portfolio.

Stipp: You've often talked about the bucket approach. We talked about it when we discussed more conservative picks. If I want to take a more aggressive stance, would my buckets look different?

Benz: Possibly. The size of the buckets may look a little bit different for more aggressive retirees than would be the case for conservative retirees. In my standard bucket strategy, I talk about using bucket one to house two years' worth of living expenses. If you're more aggressive, you might think about having that be just one year's worth of living expenses.

The same would go for bucket two. In the construct where I've done model portfolios, I've usually thought about maybe a seven-year bucket two--so, enough money in there to tide you through seven more years' worth of living expenses. In the case of more aggressive retirees, maybe they could think about having just five years in that bucket two. And then, of course, the remainder of the portfolio would be the longest-term portion and that would go in bucket three.

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Stipp: Let's talk about the investments you might put in those individual buckets if you want to take on a little bit more risk. Bucket number one is supposed to be your safe bucket. So, would you get any more aggressive with that bucket?

Benz: Probably not. The prescription for aggressive retirees would really be the same as it would for more conservative retirees, and I think the reason is that you're just not getting paid to be in cash-like alternatives today. The yields aren't appreciably higher, so you're better off just sticking with true-cash instruments for this money that you really can't afford to lose without it affecting your standard of living.

Stipp: In that case, if you were going to be more aggressive, you wouldn't have different kinds of investments in bucket one; you would have those cash investments. But you might have, as you said before, a smaller bucket one as far as years. So, you [might have one year's worth of living expenses].

Benz: That's exactly right.

Stipp: Bucket number two: This is the more intermediate-term bucket. What kinds of investments might you tilt to if you wanted to take on a little more risk there?

Benz: I think the core of bucket two for any investor, whether conservative or more aggressive, should be a sturdy and flexible core fixed-income holding. So, when I'm thinking of funds like that I'm thinking of Harbor Bond and Metropolitan West Total Return Bond, which I mentioned was one of my favorite funds that would fit within conservative retiree portfolios. I think it's also a terrific fit here. Dodge & Cox Income, another idea fund that has historically skewed toward corporate bonds as opposed to government bonds.

Another idea--in addition to that core fixed-income holding that does have some government-bond exposures--would be to maybe think about a dedicated corporate-bond fund, something like Vanguard Intermediate-Term Investment-Grade. I think that would be a good choice. It tends to be very well diversified. It also has very low costs, which I think gives the managers less of an incentive to swing for the fences in terms of taking outsized risks. They can deliver a competitive return without taking a lot of risk. And I think that that low expense ratio should be an advantage over the next decade, given how low bond yields are right now. It should be a competitive advantage for the fund.

Stipp: And you would couple that corporate-bond fund with, again, a core intermediate-term bond fund?

Benz: That's right. So, you want to make sure that you have something that really is going to give you performance that moves in the opposite direction of your equity holdings, and I think that's what you get with some of the core bond funds that we've talked about.

Stipp: You also mentioned last week that some folks will put a balanced fund in their bucket number two. What's your idea for a more aggressive option there?

Benz: We talked about Vanguard Wellesley Income fitting within the conservative portfolio. For a more aggressive option, I might think of Dodge & Cox Balanced, again mentioning another Dodge & Cox fund. I think it has a couple of advantages. One thing that I think sets it apart from some other balanced funds is a more opportunistic asset-allocation strategy. So, the managers actually have quite a bit of latitude to adjust their stock-bond allocation based on where they are seeing opportunities in the market.

The other thing that makes Dodge & Cox Balanced so easy to recommend is that this is a firm with really great resources on both the fixed-income and the equity side. That's not all that common. So, I think that that's another reason to look at this particular product.

Stipp: Let's talk about bucket number three and some potentially more aggressive options you could put there. But before we get to those more aggressive options--in general, more aggressive fair has performed well. So, if you want to be more aggressive, just right now you might want to be a little bit more cautious and ease into those kinds of investments.

Benz: That's such a great point. As I was putting together this list of holdings, I was thinking, "Gosh, I'd hate to recommend a whole bunch of funds that have really terrific return records over the past five years." I believe in reversion of the mean, and I believe that we'll see some of these holdings at some point in the future not perform so well. So, I think you want to move slowly into them, given that their performance has been so strong relative to their more conservative counterparts.

Stipp: So, these are great long-term funds, but that doesn't mean that they are going to do really well over the next few years. In fact, we could see them maybe struggle if the environment changes for funds like that.

Benz: Absolutely right. Anytime I see a fund with a great-looking relative return record, it gives me a lot of caution when I think about recommending it. I think you should move slowly to the extent that you move into any of these particular funds.

Stipp: So, given that caveat, let's talk about some of the more aggressive funds that you do like for the long term. One of them is PRIMECAP Odyssey Growth. Why do you like that one?

Benz: I like it for a couple of reasons. One, it's a growth-oriented fund. It has historically emphasized the biotechnology and technology spaces. But I like that the managers take kind of a contrarian strategy. So, they don't like to pay up for their holdings. They are very research intensive. PRIMECAP has one of the best corporate cultures of any investment firm that we cover. So, I think of it as just a great, aggressive large-growth fund. You might use it to complement maybe some sort of a deep-value fund that you might also hold: Longleaf Partners would be one. There are certainly lots of other great large-value funds. Oakmark has several as well.

You might also think about, for this portion of your domestic-equity portfolio, if you're an individual stock investor, that's fine too. You might think about tweaking your portfolio and holding some individual stocks as well.

Stipp: You also have a fixed-income idea for bucket number three, which I thought was interesting. Why would this particular investment be a good fit for this bucket?

Benz: This is Loomis Sayles Bond. It's one that I have put, I believe, in all of the actively managed model bucket portfolios I have put together. I have put it in bucket three rather than bucket two even though it's a bond fund. And the reason is that, in a lot of ways, it has more equity-like characteristics. In fact, it sometimes will own straight-up equities, but it also owns high-yield bonds at various points in time. It will own nondollar-denominated bonds. So, it will be a lot more volatile than your typical fixed-income holding. You definitely want to hold it in bucket three.

I like the idea of a fund like this versus holding, say, a separate high-yield bond fund or a separate emerging-markets bond fund because I like that you're giving the manager some latitude to be opportunistic to get out of those market segments if the team at Loomis Sayles doesn't think they're attractive. So, I like the flexibility embedded in this particular strategy.

Stipp: Christine, another set of great ideas for investors who want to take on a little bit more risk. Thanks for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.