What You Should Know Before Investing in Balanced Funds

Last Updated Jun 28, 2011 9:33 AM EDT

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.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.