Evaluation of Asset Allocation Funds
Authors: Chuck Sklader, Bill Tugaw and Paul Hackleman
What is asset allocation?
Asset allocation is an investment technique that provides investment diversification which can reduce risk and may improve returns for investors over a period of time. It provides for a strategic diversification of assets / paycheck contributions among the major asset classes, i.e., stocks, bonds and cash equivalents (often money market securities).
Asset allocation is initially a three step process. First, identify the asset categories or investment instruments that will compose the diversified portfolio. Next, determine what specific funds will be utilized and finally, what percentage of the assets and/or paycheck contributions will be allocated to each fund.
The appropriate asset allocation for an investor can be determined by the individual investor. However, many investors either do not have the knowledge or the inclination to develop their own asset allocation. After all, some employer sponsored portfolios offer fifty (50) or more funds and that can be intimidating to someone trying to develop an individual portfolio of funds from different asset categories. If they do develop a diversified portfolio based on asset allocation they rarely rebalance the allocation as the percentage of assets in each asset category changes over time or due to economic or market conditions.
Alternately, an investor can select a mutual fund that is designed to provide asset allocation as well as a periodic change to the asset allocation composition based a variety of conditions, often economic. Asset allocation funds are managed by investment professionals who provide diversification by allocating fund assets among multiple asset classes, equities, bonds and cash equivalent securities.
Many define contribution plans have three to five asset allocation funds ranging in risk from conservative to aggressive. Before the investor either determines their asset allocation or selects an asset allocation fund the investor must first determine how much risk they can handle. There are many risk tolerance tests that can help the investor determine how much risk is appropriate for them. The internet is one source, but a good source would be the provider, (recordkeeper).
A key tenet to investing is to evaluate investments against appropriate benchmarks to determine the quality of performance and to determine if the performance merits the risk the fund is absorbing to achieve that performance. Before we discuss the evaluative process for asset allocation funds we should first restate the value of asset allocation models for the investors (current participants and retirees) in public sector defined contribution plans.
In an article published in InFRE, volume 5, number 1, 2004 "Rethinking Public Sector Asset Allocation Models" the authors' state the importance of taking into consideration the lifetime income that is provided by the public employers defined benefit pension in determining the investment allocation of their supplemental retirement plan(s).
The aforementioned paragraph alludes to the investors in public sector entities, but retirees of both public and private sector employers who participated in define contribution plans, should consider asset allocation funds. Through diversification, risk can be reduced and additionally, asset allocation funds allow the investor to take advantage of retaining a portion of their assets in equities. Historically, equities have produced a higher average rate of return than other commonly held investments, but also provide the most short term risk and volatility.
Evaluation of asset allocation funds
Education provided by the employer for the benefit of the participants, including retirees, is necessary and it has been affirmed that it is a fiduciary responsibility of the employer to provide the education and to encourage participants to attend educational sessions.
Another key fiduciary responsibility of the employer is to conduct investment fund evaluations on a periodic basis, (no less often than annually). The evaluation of funds is usually performed by the provider, the employer or a consultant hired by the employer, (regardless of who performs the analysis the responsibility remains with the employer). The purpose is to provide an objective analysis of each fund against a predetermined benchmark and where a particular funds fails to perform adequately against the appropriate benchmark action must be taken, i.e., watch list or de-selection.
For nearly all asset categories appropriate benchmarks are readily available. The exception is asset allocation funds. One provider of asset allocation funds compares the fund results to the Lehman Brothers Aggregate Bond Index and compares the same results to an equity index. This is done without regard for the mix of investments. In most years the asset allocation fund will outperform the Lehman Brothers Aggregate Bond Index and under perform the equity index. This type of benchmarking doesn't provide a complete analysis of the fund(s).
Two commonly used indexes are the Dow Jones 40% US Portfolio and the Dow Jones 60% US Portfolio. The equity position, 40% or 60%, is constructed of equal weighting of six (6) U.S. equity style indexes ranging from large growth to small value. The bond and cash positions are composed of various Lehman Brothers U.S. fixed income indexes.
These indexes provide some applicability to perhaps two of the three - five asset allocation funds. However, the equal weighting of the six equity styles is a concern as typical allocations for conservative and moderate funds are more heavily weighted toward large cap and there is no inclusion of international investing in the Dow Jones models.
Morningstar, a Chicago based investment analysis firm, has developed two asset allocation indexes, Conservative Allocation and Moderate Allocation. The conservative allocation is a benchmark for funds that have 20%-50% invested in equities and 50%-80% invested in bonds and cash equivalents. The moderate allocation has 50%-70% invested in equities with 30%-50% invested in bonds and cash equivalents.
The ranges are too broad to provide an appropriate comparison for the three to five asset allocation funds typically found in employer sponsored portfolios.
A Viable Solution - Fund of Funds
The development of asset allocation funds that are composed of mutual funds already in the employer sponsored portfolio is a fund of funds approach. As part of the employer's due diligence and fiduciary responsibility the funds are evaluated on at least an annual basis. The asset allocation fund need not be evaluated since the underlying funds are evaluated at least annually. If a mutual fund needs to be replaced, and is also a fund in the asset allocation model, then the replacement fund is added in the same proportion as the fund it is replacing to that asset allocation fund(s).
The cash equivalent category can be the stable value fund rather than a money market fund. Typically, the stable value fund outperforms the money market fund and is net of expenses.
The following are examples of asset composition of three asset allocation funds:
| |
Conservative Allocation |
Moderate Allocation |
Aggressive Allocation |
| Large Cap Value |
0% |
10% |
10% |
| S & P 500 Index |
20% |
10% |
15% |
| Large Cap Growth. |
0% |
15% |
15% |
| Mid Cap Blend |
0% |
10% |
20% |
| Small Growth |
5% |
10% |
15% |
| International Growth |
5% |
5% |
10% |
| Bond |
20% |
15% |
15% |
| Stable Value |
50% |
25% |
0% |
An additional benefit of the fund of funds approach is reduced expenses. The expense of two of the three asset allocation funds of funds is considerably lower than the average expense for asset allocation funds in either of the Dow Jones 60/40, 40/60 scenarios. Accurate expense averages for the aggressive asset allocation funds are difficult to determine as the aggressive asset allocation funds typically are classified as equity funds.
| |
Conservative Allocation |
Moderate Allocation |
Aggressive Allocation |
| Total Expense* |
0.42% |
0.71% |
0.98% |
| Average Expense** |
1.20% |
1.30% |
Unknown |
In conclusion, the value of asset allocation funds is reduced risk through asset diversification and potentially better and more consistent returns. Applying predetermined benchmarks to evaluate the asset allocation funds is an inaccurate process. The solution is to develop asset allocation models (funds) comprised of mutual funds and a stable value fund from the employer sponsored portfolio. This solution is not new; it is already used by some government entities.
Regardless of what asset allocation model or fund is used, the key is to provide education to participants, including retirees, about the benefits of the diversification process that also includes a view of the constant lifetime income that is provided through the public employers defined benefit pension plan.
* The total expense is based on actual mutual funds used for the fund of funds asset allocation models in a defined contribution portfolio for a specific government entity.
**The average expense is based on the average of all funds categorized by Morningstar in the Dow Jones 40/60 and Dow Jones 60/40 indexes.
About The Authors
Chuck Sklader is a senior consultant in the Scottsdale, Arizona Branch of SST Benefits Consulting & Insurance Services, Inc. Chuck joined SST Benefits Consulting & Insurance Services, Inc. in 2001 after a thirty - two year career with a major provider of retirement plans and investment products. Chuck is currently licensed for life insurance and variable annuities and has a Registered Investment Advisor designation. He maintains series 7, 24, 63 and 65 licenses with the National Association of Security Dealers. In 2004, Chuck co-authored an article for the International Foundation for Retirement Education titled "Rethinking Public Sector Asset Allocation Models."
Bill Tugaw is the President of SST Benefits Consulting & Insurance Services, Inc. d.b.a. SST Benefits Insurance Services of Los Altos, California. He has over 30 years of diversified financial services experience and is currently licensed for life, health, property/casualty, and variable annuities, maintaining a Series 6 license with the National Association of Security Dealers. Bill is a faculty instructor for the IFEBP's (CAPPP) Program. He is the Past President of the California Association of Health Underwriters (CAHU), and the Silicon Valley Association of Health Underwriters (SVAHU). Bill is co-author of Deferred Compensation / Defined Contribution: New Rules / New Game for Public and Private Plans published in June, 2001 and Defined Contribution Decisions: The Education Challenge published in 2004.
Paul Hackleman is the Benefits Manager for San Mateo County, California and a consultant with I.C. Benefits Consulting with 23 years of employee benefit experience. In San Mateo County, he manages the County's $200 million deferred compensation benefit programs. Paul is a faculty member of the International Foundation of Employee Benefit Plan's (IFEBP) Certificate of Achievement in Public Plan Policy - Health (CAPPP) Program. Paul is a past Director with the Foundation's Board of Directors and Chair of the Foundation's Public Employee Board. He is the co-author of Public Employee Benefits: From Inquiry to Strategy published in May, 2000 and co-author of Deferred Compensation / Defined Contribution: New Rules / New Game for Public and Private Plans published in June, 2001 and Defined Contribution Decisions: The Education Challenge published in 2004.
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