These All-in-One Funds Deliver Income, but Not Without Bumps

Note: This article is part of Morningstar's November 2015 Income Investing Week special report.

All-in-one funds with decent income streams are understandably popular, especially among retirees who rely on their portfolios to deliver their living expenses. With the ability to venture into dividend-paying stocks, bonds, and hybrid securities such as convertible bonds and preferred stocks, such funds offer both simplicity and a diversified income stream.

Yet, many such offerings have been threading a fine needle in recent years. As bond yields have declined, some stock/bond funds have delved into lower-quality bonds to plump up their yields. That has generally been a profitable tack. Amid a generally sanguine environment for the economy--and, in turn, bond defaults--lower-quality bonds have outpaced higher-quality credits during the trailing three- and five-year periods. In large part because of their yield advantage, conservative-allocation funds with low-quality portfolios have soundly beaten their high-quality counterparts. In the past five years, for example, conservative-allocation funds with lower-quality style boxes have a median return of 5.36%, versus a 4.38% return for the high-quality subset.

But picking up a higher yield by taking on more credit sensitivity isn't a free lunch, as lower-quality portfolios invariably move in sympathy with the economy and the equity market. The past three months, in which stocks have sold off on concerns about underwhelming economic growth both at home and abroad, illustrate that point. Despite having higher yields, the subset of conservative-allocation funds with lower-quality fixed-income portfolios has lost roughly 2% in the past three months, whereas conservative-allocation funds with high-quality fixed-income portfolios have lost a little more than 1% during the same period.

The takeaway isn't to avoid lower-quality all-in-one funds altogether; in fact, a handful of funds of this ilk receive medalist ratings from Morningstar's analyst team. But the recent market downdraft is a reminder to consider the risks of an allocation fund's stock and bond portfolio. With that in mind, I decided to take a look at conservative funds that boast pleasingly plump yields--north of 3% in the past 12 months--but whose portfolios have a lower-quality cast. To show that the risks of lower-quality portfolios can periodically come home to roost, I further screened for the ones with Morningstar Risk ratings of "above average" or "high" and 2008 returns that place in the bottom 25% of the conservative-allocation group.

As of Nov. 18, five funds made the cut. Premium Members can click

to view the screen's output or tweak it to suit their own parameters. Here's a closer look at three of the funds that made the screen.

By charter, this fund is more income-focused than many of its peers, so it's not surprising that its yield is tantalizing. Long-term returns are also near the top of the conservative-allocation class. That owes to a larger-than-average equity stake--roughly 60% of assets versus 33% for the category--which has provided a strong tailwind as equities have outperformed bonds over every longer-term trailing period. Its emphasis on lower-quality bonds--89% of its fixed-income portfolio is rated below investment-grade, versus 22% for the conservative-allocation category--has also helped boost its yield. But the risks of that aggressive positioning can bite back. It lost 31% in 2008, for example--12% more than its typical category peer. The fund is also struggling so far in 2015, owing in part to its positions in the hard-hit energy sector. The fund still earns a Bronze rating from Morningstar's analyst team, but it's not appropriate for investors with short anticipated holding periods.

With the exception of an emphasis on foreign stocks, the baseline asset allocations of this fund of funds aren't much different from the conservative-allocation category average. But the bond portfolio has historically had a lower-quality tilt than is typical for funds in the conservative-allocation category, an emphasis responsible for both its above-average yield as well as its above-average long-term volatility. Despite the efforts of management to tamp down volatility by steering more assets to defensively minded equity managers, the fund's standard deviation over every trailing period is higher than its conservative-allocation peers. A tilt toward emerging markets has exacerbated the ups and downs. That contributes to a Neutral rating from Morningstar's analyst team, despite the presence of strong underlying managers from firms like DFA, T. Rowe Price, and Wellington Management.

Like the Franklin fund, this offering explicitly targets income production, and its 4% SEC yield demonstrates that it has delivered. A healthy helping of low-quality bonds is responsible: 77% of its portfolio is below investment-grade, versus 22% for its category peers. The fund has also delved into emerging-markets bonds. Those exposures have contributed to high volatility and risk relative to other conservative-allocation funds; it lost 26% in 2008, a bottom-quartile showing. The fund earns a Bronze rating based on its strong risk-adjusted results, experienced management team, and reasonable costs, but its income-centric portfolio--and the risks that accompany it--make it only appropriate for investors with sufficiently long time horizons.

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