For the last few years, asset allocation mutual funds worked like a dream. The funds, which divvy up money between stocks, bonds, and cash to find the most reward for the least risk, beat the pants off the Standard & Poor's 500-stock index and the average equity fund. Asset allocation became one of the hottest concepts in mutual funds--and the money poured in.

But for the asset allocators, 1994 is becoming a nightmare. Four large funds that together account for 44% of all the money in AA funds are down an average of 5.8%, about 1.5 percentage points worse than the average diversified equity fund, according to Morningstar Inc. That's hardly a disaster. But the funds have been heavily marketed to first-time investors as one-stop, low-risk investments. "Based on the last few years, an investor could have concluded an asset allocation fund always goes up," says Robert A. Beckwitt, who runs the $10.7 billion Fidelity Asset Manager Fund. Indeed, his fund has not had a down quarter in nearly four years, when the fund had less than $400 million.

EVEN SPREAD. So what's gone wrong? In a nutshell, the markets tripped up the asset allocators. Asset allocation builds on the old idea of diversification in the stock market. But instead of just buying stocks, AA funds may include bonds, foreign securities, or even gold.

Asset allocators don't expect to hit home runs in every market. Indeed, they figure that the markets will move in different directions and at different speeds, so a losing position in one market will be more than offset in one or two others. "Usually, it's the bonds which give you protection when stocks go down," says Richard Rubinstein, who runs the Oppenheimer Asset Allocation Fund.

But so far this year, AA funds have few places to turn. Even with dividends included, the S&P 500 is down 4.4% (through Apr. 18). The 10-year U.S. Treasury bond has sunk 9%. That's been deadly for such funds as Vanguard Asset Allocation Fund and the Stagecoach Asset Allocation Fund, both of which stick to large-cap U.S. stocks and investment-grade bonds. While foreign securities might have helped in other periods, going offshore in 1994 has just meant finding new places to lose money. European bonds have been sinking, too. Latin American and Southeast Asian stocks and bonds are also in a swoon.

Ironically, the only foreign market that rallied this year is Japan, up 16%. Fund watchers think a small holding in Japan kept the Merrill Lynch Global Allocation Fund slightly in the black, though Merrill officials refused to discuss the fund's strategy.

Asset allocation funds are souped-up versions of "balanced" funds, first introduced in the 1930s. Balanced funds typically maintain a fairly constant mix or balance of stocks and bonds, such as 60% stocks, 40% bonds. AA funds usually offer more asset classes, change the mix more frequently, and employ computer models to plot strategy.

CASH BETS. Fund companies started to roll out asset allocation funds after the 1987 stock market crash, since the few that were around before the crash dodged the debacle. "We started 1987 with about 60% in stocks. As stocks and interest rates went up, we kept selling stocks," says Larry Tint of Wells Fargo Nikko Investment Advisors, which runs the Stagecoach Asset Allocation Fund. Two weeks before the crash, the fund was down to 10% stocks--which allowed it to weather the storm and beat the market by three percentage points for the year.

In retrospect, the optimal asset for 1994's first quarter would have been cash, yet few allocators' models had pointed that way. Tint says at the end of 1993, the expected return from stocks was six percentage points greater than cash; from bonds, four. But he also notes that though the numbers suggested stocks and bonds would outperform cash in the first quarter, it's only a probability, and sometimes the most probable event is not the one that occurs. Still, allocators have learned not to stray from their models. "We've been doing this since 1973, and it's served us well," says William L. Fouse of Mellon Capital Management Corp., who runs $12.5 billion in asset allocation programs, including the $1.2 billion Vanguard Asset Allocation Fund.

Fidelity's Beckwitt says late last year he figured that 1994 would be more difficult than 1993, when the Asset Manager fund posted a 15.9% total return. But cash, at 3%, offered no return above the inflation rate. To protect the portfolio, Beckwitt sold his Asian stocks and scaled back the Latin holdings. He also swapped investment-grade bonds for junk bonds, which would profit from a stronger economy, and European bonds, which would benefit from sluggish growth on the Continent. That wasn't enough. In March, when interest rates continued to climb, he started selling U.S. equities as well.

Now, Fidelity Asset Manager has about 40% in stocks, a "neutral" weighting for the fund; 36% in bonds; and a hefty 24% in cash. About a third of the assets are overseas. He thinks some of the beaten-up emerging-market bonds offer good value, as do U.S. junk bonds.

So far, the investors who embraced asset allocation funds are sticking with them. Once the markets both in the U.S. and overseas start moving on their own fundamentals instead of all operating in lockstep, that tenacity is likely to be rewarded.

      Fund                                   Total   Assets
                                            return* Billions**
      FIDELITY ASSET MANAGER                 -5.56%  $10.7
      FIDELITY ASSET MANAGER: GROWTH         -5.61   2.7
      CAPITAL WORLD GROWTH & INCOME          -2.50   2.2
      SOGEN INTERNATIONAL                     1.13    1.8
      VANGUARD ASSET ALLOCATION              -5.81   1.2
      STAGECOACH ASSET ALLOCATION            -6.10   1.1
      DEAN WITTER STRATEGIST                 -2.75   0.8
      USAA INVESTMENT CORNERSTONE            -2.81   0.8
      ZWEIG MANAGED ASSETS B                 -2.27   0.5
      COMSTOCK PARTNERS STRATEGY O           -3.99   0.5
      DREYFUS CAPITAL VALUE A (PREMIER)      -1.35   0.4
      PRUDENTIAL FLEX. CONSERV. MGD. B       -4.02   0.4
      PHOENIX TOTAL RETURN                   -3.03   0.4
      PRUDENTIAL FLEX. STRATEGY B            -5.08   0.4
      STANDARD & POOR'S 500                  -4.40
      *Appreciation plus reinvested dividends and capital gains, before taxes, Jan. 1-Apr. 18, 1994       **Assets under management as of Mar. 31, 1994                            DATA: MORNINGSTAR INC.
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