Balancing Act
Adviser Allan Chappelle is not joining the rush toward target-date funds as a default investment for sponsor clients. That reluctance has a lot to do with his concerns not only about risk, but also about benchmarking.
Instead, the President of Birmingham, Alabama-based Chappelle Consulting Group, Inc., advises clients to use balanced funds as their default investment. “We have had balanced funds for 40 or 50 years, and we have got a whole slew of generally accepted criteria for evaluating these funds.”
Balanced funds got the go-ahead as a qualified default investment alternative (QDIA) from the Department of Labor last fall (see “Default Vault,” Winter 2007). However, the final QDIA regulations do not spell out a specific asset allocation that such funds must have, and advisers who give them a look will find that they can vary substantially on the equity/fixed-income split and on the types of assets in which they invest.
The QDIA regulation instructs fiduciaries to consider the age of the participant population as a whole when selecting a balanced fund or other risk-based, multi-asset portfolio as the default investment, says Fred Reish, Managing Director and Partner at Los Angeles-based law firm Reish Luftman Reicher & Cohen. “Most commentators believe that the traditional balanced-fund allocation, approximately 60% equities and 40% fixed income, will work in the vast majority of cases,” he says. “However, if a participant population is particularly young or particularly old, a more aggressive or more conservative allocation may be appropriate.”
Some commentators have expressed concern over the need for that analysis, Reish observes. “The DoL pointed out in the preamble to the QDIA regulation that it is the same analysis that fiduciaries have been doing for years to select the asset allocation and investments for defined contribution plans, like profit-sharing plans,” he says. “As a practical matter, there is very little likelihood that, if a fiduciary picks a traditional balanced fund, there will ever be any claim that the fiduciary breached its responsibilities.”
The classic balanced fund calls for an allocation of 60% equity and 40% bonds. “What traditionally has been called a balanced fund—i.e., a 60/40 fund—is very similar to a moderate target-risk fund,” says Andrew Clark, fund-rating company Lipper’s Head of Research for the Americas, That classic balanced fund has a classic benchmark of 60% S&P 500 and 40% Lehman Aggregate Bond Index, sources say.
However, that does not make sense anymore for some balanced funds, given that they invest in more than stocks and bonds, and diverge from 60/40. Some of these funds recently may have cut back their equity exposure due to the volatile markets, but investments such as the BlackRock Global Allocation Fund, UBS Global Allocation Fund, and Franklin Income Fund historically have all had greater than 60% allocation to equities, an industry source says.
The good news: Despite being a moving target in some cases, sources say, at this point, balanced funds fare better with benchmarking than lifecycle funds. “Benchmarking can sometimes be an issue but, overall, these funds have more consistency from fund to fund than target-date does at this point,’ says Don Stone, President of Chicago-based Plan Sponsor Advisors, LLC. Adds Clark, “Balanced funds do tend to stay within the range defined in the prospectus—be it 60/40, moderate, or however you term it—so a benchmark made up of similar funds still retains its value across time.”
Yet, with the lack of cohesiveness around the “balanced fund’ name, Clark says, “At a minimum, just be aware of what your quote-unquote “balanced fund” is doing these days.”
All Over the Map
Lipper used to have an index for balanced funds. “However, we saw that something can call itself a balanced fund, and it can be all over the map,” Clark says. “That is why we put them in a target-risk category and split them up based on equity allocations.” The target-risk category divides funds into aggressive, moderate, and conservative styles.
However, Lipper’s reclassification for balanced funds has met with some opposition. “Some of our clients (the “producers” of balanced funds) are pushing back and saying, “We want the old balanced-fund category back, Clark says. “I think they are asking for it because they pitch balanced funds, which are probably easier to sell because they are familiar.” Lipper may shift in 2009, retaining the target-risk category but resuming with a balanced-fund category. “We would define a balanced fund as being something close to 60/40,” he says, “such as within 5% on either side.”
One big benchmarking issue: Percentage allocations within balanced funds can vary a lot. “Until sometime in the current decade, a balanced fund was traditionally 60/40,” Clark says. “Now, one balanced fund is 30/70, and another is 70/30.” Some aggressive balanced funds hold from 70% to 90% equities, he says, so using the traditional 60/40 benchmark to evaluate them does not work.
In a world where star ratings matter a lot, investment companies can mislabel products intentionally so that they end up outperforming their category, says Ron Weiner, President and CEO of RDM Financial Group, Inc., in Westport, Connecticut. “You cannot necessarily believe the label, and performance can be skewed to look any way you want it to look,” he says. “The idea is to cut through it and get to what the fund really is doing, and hold [the fund managers’] feet to the fire.”
While some balanced funds’ allocation remains static, others have a lot of leeway to shift holdings. “Because of the movement within the balanced fund, the manager may swing from a 60/40 to a 70/30 and the plan sponsor may not be aware of the shift,” says David Snetro, Senior Vice President of Retirement Services at RDM Financial Group. Some plan sponsors may end up with a different investment mix than they believed they chose, Weiner adds.
Recommends Clark, “Read the prospectus so that you understand whether 70/30 is the most they can go, they least they can go, or the average.”
Balanced funds also invest in more types of assets these days. “Some of them are doing commodities, some invest in currencies, some in ETFs,” Clark says. “These are all perfectly OK to invest in,” he says, but advisers need to take that into account when benchmarking.
Broadening holdings to areas such as global allocations also influences results. “There is now a new generation of allocation funds that are trying more wrinkles, things like TIPS and commodities,” says Russel Kinnel, Director of Fund Research at Morningstar, Inc. “I would not say that the ones that were out there already have changed much.” Introducing a balanced fund with more diverse investment types gives providers a new way to compete for assets, he says. “It is another way to differentiate funds in a crowded field.”
What’s an Adviser To Do?
Do not focus on raw performance alone in benchmarking these funds, Chappelle recommends. “Most participants, when they pick a fund, just pick the one with the best five-year track record,” he says. “That performance could have been achieved four years ago with a different manager, all in one year when the manager got lucky and made 40%, which blows the five-year average out the roof.”
Sources point to five focus areas to examine when benchmarking balanced funds:
• Peer-comparison performance. Look not just at gross performance over a five-year period, Chappelle says, but also at average annual return and a rolling average return on a quarterly basis to ferret out any fund that just had one great year. He utilizes the Morningstar Moderate Allocation Universe to make peer comparisons and looks not only at annualized return and standard deviation, but also at a fund’s excess return over the benchmark, information ratio, and tracking error versus the Morningstar universe.
This is where it becomes important to zero in on the actual allocation versus assuming the classic 60/40 setup. Morningstar’s Moderate Allocation category includes funds with 50% to 70% in equities.
“Between 50% to 70%, that is a pretty big range,” Kinnel says. “If you are talking about an index, you need one with roughly the same stock to bond mix and that reflects the underlying stock and bond portfolio, and there are so many different variations. So, there are definitely limits to an index and peer group.”
• Stated versus actual style. Advisers need to scrutinize a fund’s holdings and determine if they jibe with what the prospectus said the fund would do, Weiner says. “Whether they make money or lose money is not as important as holding to their stated philosophy,” he believes. Most balanced-fund managers “are pretty well constrained,” Clark says, so advisers need not worry that they will shift investments too much.
National Retirement Partner’s tool for its advisers includes a chart that plots manager style on a graph, using value/growth as one axis and small/large as the other axis. The tool allows Chappelle to see to what extent a fund’s investments fell into the Russell 1000 Growth, Russell 1000 Value, Russell 2000 Growth, and Russell 2000 Value categories. He also looks at style over five years, both at a single point and over a rolling time period. “That tells you what types of stocks and bonds they have been buying over the past five years and, on a rolling basis, it tells you for each quarter,” he adds.
• Manager impact. Chappelle looks at a fund’s information ratio, which measures the excess return over or under the benchmark divided by the amount of risk the manager took compared to the benchmark. That gets compared to the Morningstar Moderate Allocation Universe based on 36-month moving windows that are computed monthly.
Also find out if the fund saw any management changes during the benchmarking period, Weiner says. “It is just as important to know that the management did not change because, if it does, the investment philosophy can change.”
• Relative expense ratio. The cost of balanced funds ranges from about 30 basis points to 1%, Chappelle estimates. The main difference in pricing comes when subadvisers are involved and that leads to an additional wrap fee, says Jennifer Flodin, Co-Founder and COO at Plan Sponsor Advisors. To benchmark balanced funds’ cost, an adviser can access information such as Morningstar’s median figure and use that as the basis for comparison, she says.
Expense ratios might vary based on the following factors, Chappelle says: stock/bond ratio (the more stocks, the higher the expense); foreign stock/U.S. stock ratio (the more foreign, the higher); large stock/small stock (the smaller, the higher); the diversity of asset classes such as real estate and foreign bonds (the more, the higher); and the sophistication of the risk-management techniques (the more sophisticated, the higher). “Also, do not forget the typical market forces, where the best performance can demand a higher price,” he adds. “Most of my clients would rather have the best-performing balanced fund than the cheapest.”
• Risk and volatility. Paul D’Aiutolo, an institutional consultant at UBS in Rochester, New York, tries to delve into a balanced fund’s risk, using measurements like the Sharpe ratio. Also, look at how much of upmarkets and downmarkets a fund captured versus the peer group, Chappelle says. For participants, he says, a fund’s volatility and consistency are crucial. By using funds with little volatility, he adds, “You will create the least amount of angst for participants who are looking at this on a quarterly basis. Your ultimate objective is to get them to leave it alone, to let the experts do their job.”
*Illustration by Red Nose Studio