Allocation Funds Are on the Rise

Before last year's multi-market meltdown, many investors divided their assets using a rule of thumb that put 60% in equities and 40% in bonds. And almost everyone followed the investing mantra of "buy and hold." But the severe turmoil that jolted the markets in 2008 left many questioning whether such simple rules still make sense.

That's leading to growing interest in funds and strategies that try to switch opportunistically among different asset classes—anything from U.S. stocks to high-yield bonds to emerging market debt. The idea is to cut down on losses by getting out of a market if it looks overheated and switching into a market that's cheap and out of favor. Overall, funds in the category lost 25% for the 12 months ending May 11, and 4% annually over the past three, according to Morningstar. That compares with the Standard & Poor's (MHP) 500-stock index's 33% loss over the past year and its average annual loss of more than 9% for the past three.

The notion of avoiding losses obviously resonates with investors. Van Kampen Investments, Legg Mason (LM), and Baring Asset Management have all launched new products, known as tactical allocation or world allocation funds, in the past few months. "These strategies are going to be huge," says David D'Amico, a financial adviser and president of Braver Wealth Management in Newton, Mass. But advisers and fund analysts warn that the sector offers a particularly broad menu of approaches to the basic concept. Hidden in the average performance of the funds is among the widest divergence of individual fund returns of any category, Morningstar (MORN) analyst Michael Herbst notes. For the year ended Mar. 31, when the funds lost on average 29%, the difference between the best and worst funds was a chasm of 54 percentage points.

Morningstar prefers two of the larger, more seasoned offerings, the $24 billion BlackRock Global Allocation Fund and the $67 billion American Funds Capital Income Builder Fund. Both have experienced management teams and long records of above-average performance. But neither has beaten the $12 billion Ivy Asset Strategy Fund and its sister fund, the $2.6 billion Waddell & Reed Advisors Asset Strategy Fund, which have the best three-year records. The Ivy approach benefitted from a bet on gold and a prescient shift away from U.S. stocks last year. "We're at a time when I like having the flexibility to not be invested in any particular asset class," says Michael Avery, the funds' co-manager. "We're still in treacherous waters."


Finding the right fund to meet an investor's risk tolerance requires some digging. Start by checking which index (or indexes) managers use as their benchmark. Some seek to measure themselves purely against the stock market; others compare themselves with a less volatile blend of stock and bond indexes. The First Eagle Global Fund compares itself to the MSCI World Index, which measures the performance of all the world's stock markets. That reflects the fund's general focus on equities. By contrast, the Thornburg Investment Income Builder Fund cites a blend of 75% of the MSCI World Index and 25% of the Barclays Capital U.S. Aggregate Bond Index.

Still, fund managers might not always live up to the targets for risk implied by their benchmark. In the fourth quarter of 2008, First Eagle, the more equity-oriented fund, lost almost 11%. The Thornburg fund lost over 15% in its worst quarterly result.


It's also important to find out how flexible a manager can be. The best use of a tactical strategy sometimes requires putting a lot of money in low-yielding cash accounts, says Mebane Faber, author of The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. Managers should also have the ability to invest beyond stocks and bonds into real estate and commodities, says Faber, whose book offers a do-it-yourself guide for asset allocation.

Legg Mason's new fund, the Legg Mason Permal Tactical Allocation Fund, is taking a different approach from most. The money manager's Permal unit, which offers funds that invest in a range of hedge funds, will oversee it. Permal will make asset allocation decisions and mix Legg Mason funds with those of rivals, index funds, exchange-traded funds, and closed-end funds. With a minimum of just $1,000 and the ability to let investors withdraw money at any time, it's a change for Permal, which typically sets up funds of hedge funds that have minimums of millions of dollars per investor and allow limited withdrawals.

Where are the tacticians putting money? Avery, the Ivy co-manager, thinks U.S. consumers are unlikely to return to their free-spending ways any time soon. And since the U.S. consumer accounted for almost 25% of global gross domestic product in the good times, the world economy may struggle until consumers in regions like China take up the slack. To hedge his fund's 55% exposure to stocks, Avery has added put options, which pay off if stocks sink, as insurance against a decline. The options cover slightly more than half the value of his stock position, leaving the fund with a 25% exposure. The rest of the fund is split almost equally among cash, gold, and bonds.

First Eagle co-manager Abhay Deshpande is finding the best values in Japanese equities. About 80% of stocks there trade for less than book value, and 20% for less than the amount of cash and other short-term assets minus interest-bearing liabilities. And at the Thornburg Income Builder Fund, managers like the telecommunications sector, particularly outside the U.S., says co-manager Brian McMahon. High-yielding choices include Vodafone (CHL) and Telefónica (TEF).

with Lauren Young and David Bogoslaw

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