What You Should Know Before Investing in Balanced Funds

One thing the mutual fund industry does well is to create product and then create demand for that product, even when the product may not be in investors' best interests.

Two mutual fund products that have proliferated in recent years are balanced funds and target-date funds (TDFs). The idea behind these products is fundamentally sound -- they create a multi-asset class fund (or fund of funds) that provides broad diversification and perhaps discipline.

These funds can be structured to accommodate investors covering the full spectrum from aggressive (100 percent equity allocation) to very conservative (20 percent equity allocation). The difference between the two types of funds is that while a balanced fund might maintain a constant asset allocation (though likely won't if it's actively managed), a TDF will have a predetermined "glide path," gradually reducing the exposure to equities over time.

Benefits They allow investors to hold in one fund a diversified portfolio that can include exposure to both U.S. and international (typically international large-cap and possibly emerging markets) equities. They can also include exposure across the asset classes of small-cap, large-cap, value and growth.

The funds automatically rebalance their assets to the targeted exposures, providing discipline (something only a minority of investors has demonstrated the ability to do on their own).

Negatives Unless funds are all-equity funds, combining equities and fixed income assets in one fund results in holding one of the two assets in a tax-inefficient manner. If funds are held in taxable accounts, you're holding the fixed income assets in a tax-inefficient location. If funds are held in tax-deferred accounts, the equities are being held in a tax-inefficient location (losing the benefits of long-term capital gains treatment, the ability to loss harvest, the ability to use the asset as a means of making a charitable contribution and avoid the capital gains tax, and the potential for heirs to have a step-up in basis upon death).

Taxable Account Issues When you hold balanced funds or TDFs in taxable accounts, you lose the ability to loss harvest at the individual asset class level. However, an offsetting benefit is that the fund should be able to rebalance internally, using cash flows and dividends, which is a more cost- and tax-efficient way to rebalance than buying and selling individual asset classes.

Also, when equities are held in taxable accounts, they should be tax managed. I'm not aware of any balanced funds or TDFs that tax manage the equity portion (which makes sense since the fund doesn't know in which location it will be held).

Finally, bonds held in taxable accounts should be municipal bonds, not taxable bonds. Unfortunately, almost all of these funds hold taxable bonds.

Tax-Advantaged Account Issues When these funds are held in tax-advantaged accounts, you lose the ability to use any foreign-tax credits generated by the international equity holdings. (It's important to note that such funds that are actually "funds of funds" mean the loss of the foreign-tax credit, even in taxable accounts.)

Next, we'll cover perhaps the most important consideration when investing in balanced funds or TDFs.

Photo courtesy of Rachel Coleman Finch on Flickr.

• Next: How Much Do Balanced Funds Cost You?
  

How Much Do Balanced Funds Cost You? Since the asset allocation of your portfolio determines almost all of its risk and return (virtually 100 percent if you use passively managed funds), this is the most important decision you make. Your asset allocation should be based on your unique ability, willingness and need to take risk. And those factors not only change with the passage of time, but can be greatly impacted by life events, both positive (such as inheritances, job promotions and even bull markets) and negative (such death, divorce, disability or job loss).

As discussed in The Only Guide You'll Ever Need for the Right Financial Plan, you should consider your unique circumstances when deciding on how much exposure you should have to the various asset classes. This includes not only the stock-to-bond allocation, but how much (if any) exposure you should have to international equities, emerging market equities, small-cap and value stocks, commodities and real estate. Thus, unless a balanced fund has an allocation that closely matches the appropriate allocation for you, the fund won't be a good fit. The same is true for TDFs. However, with TDFs, there's another problem -- the glide path won't likely match what is appropriate for you, and certainly won't if there are unexpected events such as the ones we discussed.

Costs Matter The greatest benefit of mutual funds is their ability to provide broad diversification at low costs. This is an important benefit for the equity portion of the portfolio -- broad diversification minimizes/eliminates the idiosyncratic (and thus uncompensated) risk of owning individual stocks. The broad diversification that only a mutual fund can effectively provide is also important if your bond allocation is to risky investments such as corporate bonds, emerging-market bonds, preferred stocks and convertible bonds.

However, if your bond holdings are limited to safe investments such as Treasuries, government agencies and FDIC-insured CDs, there's no need to incur the expense of a mutual fund. With safe investments such as these, the only benefit of a mutual fund is convenience. (In the case of balanced funds and TDFs, the disciplined rebalancing they provide can be another benefit.) Let's see how this impacts the effective cost of balanced funds and TDFs.

These funds have expense ratios that can run from as low as about 0.2 percent for Vanguard's low-cost target retirement funds to 1.5 percent or more. The average expense ratio is in excess of 1 percent.

Now consider an investor who wants a 50 percent equity/50 percent bond allocation. Also assume that the balanced fund or TDF she chooses has an expense ratio of 1 percent. Let's also assume that our investor's bond holdings are all in investments such as Treasuries and FDIC-insured CDs. These investments can be purchased independently at little to no cost and without any ongoing fund expenses. Thus, the entire burden of the expense ratio of the fund is being carried by the equity portion. In effect, the equities are really costing her 2 percent.

Now consider that our investor prefers the convenience of a mutual fund and needs it because she wants to own bonds with credit risk that needs to be diversified. The investor can purchase the appropriate ETF or a Vanguard bond fund for about 0.15 percent. That still results in an effective expense ratio for the equity allocation of 1.85 percent. In either case, it's a steep price to pay for the sole benefit of discipline -- though the evidence suggests that even that price would be a good "investment" for many investors. Alternatively, one could hire a good financial advisory firm to not only develop an investment plan and provide the needed discipline, but also integrate the investment plan into an overall estate, tax and risk management (all types of insurance) plan.

Individually, each of the negative features of balanced funds and TDFs that we discussed may provide a sufficient reason to avoid these funds. Collectively, they're very damaging. And make sure you do that "math" so that you understand the costs of these funds as compared to the alternatives.

The bottom line is that it's highly unlikely that these funds will be the most efficient way for you to achieve your goals. The more efficient investment strategy is to hold the individual assets in separate funds and in the most tax-efficient location. Unfortunately, that's only a sufficient condition for investment success. The necessary condition is to have the discipline to adhere to your plan, and adapt it appropriately along the way.

If you lack either the knowledge or the discipline to develop and carry out an overall financial plan, you should hire an investment advisory firm to do that for you -- one that provides a fiduciary standard of care, invests its own assets in the same vehicles it recommends, and bases its recommendations/strategy on the "science" of investing (evidence from peer reviewed journals), not its opinions.

Photo courtesy of Willow&Monk on Flickr.

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