Our Favorite Allocation Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar recently developed some new categories for funds that split their assets among stocks and bonds. Joining me to share his favorite conservative options within these groups is Russ Kinnel. He is director of manager research with Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: In your most recent issue of Morningstar FundInvestor, you drilled into these new allocation categories. Let's start by talking about what motivated the change. Why are we looking at these allocation funds differently in terms of categories than we did in the past?

Kinnel: There are a couple of reasons. One is that it continues to grow. So, there was a time when we had them all in one group, then we split them up into two, then three. And as the groups expand, as there's more offerings, it makes sense to slice up a little more narrowly and that also helps for understanding performance better. If you have more similar peer group then that performance can tell you more; whereas if you have a broader group, maybe it's just telling you, well, this fund skews toward the low equity weighting or the high equity weighting of the group. So, there are a couple of reasons.

Then on top of that I think we wanted to use the numbers for the names that we're telling you how much is in equities rather than labels like moderate and conservative because you could be in the old conservative group; but let's say your fixed income was largely high-yield and a lot of credit risk then you might not really be what we would consider conservative. So this was a little more plain labeling as well as splicing them into a little more narrow groups.

Benz: So, this doesn't affect some funds that split their assets among stocks and bonds, so target-date funds still have their own categories. The world allocation group is what it was before. The tactical asset allocators, they are still in their own category. But this is the funds that were in the moderate, conservative, and aggressive allocation groups. Let's talk about the categories. They range from very equity to more conservative and today you're going to highlight some of the more conservative options within these new categories. Let's start with just a general question, though. How should investors think about using these funds that maybe are predominantly bonds but also have a stake in stocks?

Kinnel: Well, one way to look at them is if you want to dial up the income a little in your portfolio, this is one way because obviously you can do that with bond funds, maybe you could move into higher yield but this is another more diversified way that you're getting some of that income from equities and of course, you're going to have a little greater return potential as well. But if it's mostly bonds then you're also muting some of the downside.

Benz: So, let's get into a couple of Gold-rated options. They are falling within our 15% to 30% equity categories. Let's start with Vanguard Life Strategy Income. It's a Gold-rated fund among the most conservative stock bond funds in our universe.

Kinnel: That's right. It's a fund that's got about a 20% equity weighting and essentially just broken down into four index funds. So, very simple. You've got international stocks, domestic stocks, international bonds, domestic bonds, all indexed, super cheap, just 12 basis points, so very straightforward. That's one way to boost your income is by keeping fees low. So there is not a lot of credit risk in the bond funds or any other real big risk. It's just fees are very low. That's going to boost the income a little and obviously it's a nice, simple easy-to-understand fund.

Benz: And it's not gunning for income by venturing into lower-quality bonds, for example. It's a pretty high-quality portfolio.

Kinnel: Exactly. So, it's high quality, it's very straightforward and that allows them to charge very low fees.

Benz: Another fund I know our Morningstar.com readers and viewers love is Vanguard Wellesley Income. This is another Gold-rated fund. It also lands at the conservative end of the allocation spectrum.

Kinnel: That's right. It's got a little more equity. It's in our 30 to 50 equity allocation bin because it's about 40% equity. This one is run by Wellington. Now, you're getting active management but for only 23 basis points. So, Wellington just does a very good job. You get kind of a value equity portfolio and a mild-mannered fixed-income portfolio, but active management and it's really just an outstanding fund. You're going to get some good capital appreciation and income along the way, but you can also look at what happened, say, in '08 and see how much less it lost than say a pure equity fund. So, it's a really appealing fund.

Benz: One thing I've heard our readers kind of worry about in their discussions on our boards has been this issue of potential interest-rate sensitivity at Wellesley Income, whether the bond piece in particular would be vulnerable to interest rate changes. What's your take on that question?

Kinnel: Yeah, it does have some interest rate sensitivity. It's got significant duration. It's not like owning a long-term bond fund. But to be sure, there is some interest-rate risk there. Anytime you have a fund that's mostly in high-quality bonds, you're going to have interest-rate risk unless it's all short-term. So, yes, there is interest-rate risk and I think that's among the risks there. Generally, interest-rate risk, it's not so long though that I think you're going to get crushed if interest rates go up barring a tremendous spike and of course, people have been predicting a big spike for years and it never happens. So, I think that tells us something. But yes, one of the significant risks you have in this fund is interest rates could rise and that could hurt it. But generally, it's a fund that loses less in just about any kind of market calamity. So, I think generally you're getting compensated pretty nicely for that risk.

Benz: Let's talk about another fund. This I think of as a little more idiosyncratic type fund. This is Berwyn Income, another fund that earns a high rating, in this case, it's a Silver-rated fund currently.

Kinnel: Right. We talked about why some conservative-labeled funds are not that conservative and this is a good example because it's in now our new 30 to 50 equity bin and its fixed income has a fair amount of credit risk. It's got high-yield bonds. It's got preferred. It's got convertibles. So, those are all significantly riskier than, for instance, the two Vanguard funds we mentioned. So, yes, it doesn't have a lot of equity, but it's still got some more risk. On the equity side, it's got a value portfolio but occasionally it goes deep-value enough that it can get burned. So, good fund. You can look at those returns are pretty appealing. You have experienced managers. The fund charges 67 basis points which still a pretty good cost. So, a good allocation fund but definitely not one you would want to think of as being super conservative, particularly compared with those two Vanguard funds.

Benz: Right. And you might not want to use it as kind of a core holding whereas those two Vanguard funds could be reasonably a really large holding in, say, a retiree portfolio.

Kinnel: Right. It's a nicely run fund. But yeah, I wouldn't make this 40% of my portfolio because you have some significant risks in that portfolio.

Benz: Another Silver-rated option, this is T. Rowe Price Personal Strategy Income. Let's talk about that one.

Kinnel: Yeah. The first Vanguard fund we talked about was a fund of funds within index funds. This is a fund of funds with actively managed T. Rowe Price funds, but it's a really nice mix because you've got a number of T. Rowe's best actively managed funds and so you combine all of that into a nice low-cost vehicle, 58 basis points, it's pretty cheap and again, T. Rowe has the breadth to make a fund like this work. There's not a lot of firms that have enough good actively managed funds in equity and bonds and foreign to make that work, but T. Rowe is pretty strong. And also, their underlying funds are pretty straightforward. So they don't veer off in surprising directions. So, again, I think that makes this fund that combines all of that a pretty appealing fund.

Benz: So, there is a little bit of latitude with the allocation committee that oversees this fund to move things around a little bit?

Kinnel: That's right. They've got a latitude to make some allocation calls. Generally, they are not making them very dramatic. Generally, you have about 40% equity, 60% fixed income. But yes, they can make some moves. So, I think you want to factor that in; is that something you want? On the other side, they are not very dramatic moves. So it's not like, say, PIMCO All Asset or something, where you have some really big tactical moves.

Benz: Russ, thank you so much for being here to discuss this research.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.