Don't Put Your 401(k) at Risk by Chasing Performance

Well, that was a fine first quarter for your 401(k). Your stock holdings probably show a pretty nice gain as the Standard & Poor's 500 stock index gained 5.9 percent and the broader Wilshire 5000 index -- the only stock index you should ever care about according to MoneyWatch's Allan Roth -- shot ahead 6.2 percent. On the bond side, the good news was that after a price drop early in the quarter, most pockets of the bond market rebounded. At quarter end, the Barclay's U.S. Aggregate bond index managed a 0.40 percent gain, so no lost ground. Net-net, that means your diversified portfolio did pretty well.

That's the good news. The more troubling news is that, well, plenty of us can't seem to shake the performance chasing bug. Bank loan funds, natural resource funds, and high yield corporate bond funds (a.k.a., junk bond funds) are taking in the most new money in the early going of 2011, according to the Financial Research Corp (FRC), and surprise, surprise, all three have had strong performance over the past few months. Each investment can make sense within your portfolio, but only as a small supporting role to complement your core diversified stock and bond holdings. If you're loading up more than 5 percent to 10 percent on any of these "hot" segments, you're putting your 401(k) at risk.

About That Performance Chasing

• Bank Loan funds, also known as floating rate funds, attracted the most new money in the first two months of the year, among 20 Morningstar categories that are tracked by the FRC. The $10.2 billion in net new inflows for bank loan funds is five times what they took in during the first two months of last year. The allure of these bond funds is easy to see as we're now in year three of Federal Reserve chairman Ben Bernanke keeping short-term Treasury yields below 2 percent. Bank loan funds are often pitched as alternatives to cash or short-term bonds, and with fat yields these days north of 3.5 percent, they look pretty attractive. Unlike typical bonds that have a set interest rate -- that's the fixed in fixed income -- the interest rate on these types of bonds rises along with inflation. That sure sounds like a nice win-win: a bond that keeps up with rate hikes. But hold on a sec. Do not for a second think these are cash or short-term bond substitutes. When the market and the economy head south, watch out. Let's look at Fidelity Floating Rate High Income and Eaton Vance Floating Rate A, two of the best in class. In 2008, they lost 16 percent and 30 percent, respectively. If you want to buy into floating rate funds, don't peel off money from truly low-risk funds and put it in these. That's not an apples-to-apples trade. And be sure to read what MoneyWatch blogger (and financial advisor) Charlie Farrell has to say about floating rate funds. That might help you carefully consider how much of your overall portfolio belongs in these funds.
• Natural Resource funds were close behind in popularity, bringing in a net $10.1 billion in new money in the first two months of the year, compared to just $472 million in the first two months of last year. With all the reports that we've got ourselves a global commodity squeeze with emerging markets hungry for any metal or natural resource that can be pulled out of the ground, these funds are also compelling. As is their 24 percent average gain over the past 12 months. Again, just keep it in moderation; a commodity hedge within your overall portfolio makes sense. But more than 5 to 10 percent is moving you away from a sound diversified portfolio.
• High Yield Corporate (Junk) funds have attracted $8.8 billion through the first two months of the year, compared to a net outflow of $434 million in early 2010. Junk funds are actually in a dead heat with the Large Blend funds for the third spot in FRC's fund flows ranking for the first two months of the year. That's pretty startling when you consider that the large blend category -- think funds that track the S&P 500 -- is the very definition of a core holding, and junk should be, at best, a peripheral part of your portfolio. Again, it's the Bernanke factor at play. The Treasury funds in your 401(k) are probably yielding less than 3.5 percent, while the junk fund yields twice as much. Moreover, the average junk bond fund had a stock-like total return of 13.7 percent over the past year. You have heard there are no free lunches, right? Well, here's where junk can cost you: when the markets and the economy hit a rough patch, junk doesn't just stumble, it tumbles. In 2008, an index of junk bonds lost 20 percent. As I mentioned in an earlier post, if you're hot for junk, treat it more as a stock holding, rather than as part of your bond portfolio. As with bank loan funds, you will be setting yourself up for some ugly surprises if you trade in money market funds or solid investment-grade bond funds for the seeming appeal of a junk fund.

• Hidden Risk in Bank Loan Funds
• Is the Bond Bubble Ready to Burst?
• Where to Stash Your Cash