by: Randy Myers
from: Nation's Business
November 1998

Want to make life easier for participants in your company's 401(k) plan?  Add a fund of funds to their menu of investment choices.  Better yet, add several.

Ordinary mutual funds - the most popular 401(k) investment options - typically invest in stocks and bonds.   A fund of funds invests in other mutual funds.  Also known as life-cycle funds and multifunds, funds of funds allow investors to build a broadly diversified portfolio by making a single investment choice rather than several.

"I define my job as being a surrogate for the investor," says Robert Markman, who presides over the Markman family of multifunds as president of Markman Capital Management in Minneapolis.  "I do what you would do yourself if you had my time, resources, and experience."

Because no two investors have the same investment objectives, most funds of funds are designed to synchronize with an investor's age, investment horizon, or tolerance for risk (conservative, moderate, or aggressive).  That makes them refreshingly easy to use for workers who don't have the time, inclination, or ability to mix and match from a potentially bewildering array of investment options in their 401(k) plans.

Many fund companies offer questionnaires that participants can use to help decide which fund of funds is best suited to their needs.

A Burden Removed
"In every company, you have a few astute individuals who manage their own money and understand stocks and bonds and asset allocation, but the vast majority don't do that and don't necessarily have the tools they need," says Roxanne Fleszar, president of Financial Resources Management Corp., a Peabody, Mass. investment advisory firm that is a consultant to qualified (tax-advantaged) retirement plans.  "A lot of them are happy to have the investment burden taken off their shoulders [with a fund of funds]," she says.

Funds of funds are already gaining popularity.  Greenwich Associates, a research and consulting firm in Greenwich, Conn. surveyed nearly 500 corporations about the investment options in their 401(k) and profit-sharing plans last year and found that 16 percent of respondents were offering life-cycle funds, up from 10 percent a year earlier.

IBM Corp. is a recent convert.  IBM created four Life Strategy funds for its 401(k) plan in 1996.  Each invests in differing proportions, in other mutual funds offered through the plan.

The most conservative Life Strategy fund keeps 80 percent of its assets in bond funds, for example, and just 20 percent in stock funds.  The most aggressive fund takes just the opposite approach.  It has 20 percent of its assets in bond funds and 80 percent in stock funds.  (Stock funds generally offer higher potential returns but greater short-term volatility than bond funds).

Participants in the company's 401(k) plan are given guidelines for assessing their investment needs and their tolerance for risk, which helps steer them to the appropriate Life Strategy fund.

The asset allocation mix in the IBM Life Strategy funds stays relatively constant.   As investors' risk-reward tolerances change, they can switch money into a different fund.

That's the approach taken by most lifecycle funds that define themselves principally by the degree of risk they take on, including those offered by the Vanguard Group, the nation's second-largest fund company.

A View Toward Retirement
Fidelity Investments, the nation's largest fund company, takes a slightly different tack in matching investors with the right life-cycle fund in its stable.   Each of its Freedom life-cycle funds is constructed to reflect the approximate year in which an investor will be retiring and the amount of risk appropriate for that investment time frame.  (The longer until you retire, the more risk you can afford to take in hope of earning higher returns).

Fidelity's Freedom 2000 fund, for example, is designed for investors retiring in the next several years.  It allocates only about 41 percent of its assets to stock funds, 44 percent to bond funds, and 15 percent to money-market funds.  Fidelity's Freedom 2020 fund, by contrast, allocates about 80 percent of its assets to stock funds and 20 percent to bond funds; nothing is put into money-market funds.

Unlike the IBM and Vanguard funds, the asset allocation mix in each of the Freedom funds changes over time, it becomes more conservative as the target retirement date gets closer.  The idea is that investors never need to change funds, even as they approach retirement age and become less willing to take risks with their money.

Simplifying A Decision
For Jim Rich, the IBM senior investment advisor who oversees his company's $14 billion 401(k) plan, life-cycle funds meet the "kiss" (keep it simple, stupid) test.  They simplify the most critical decision every 401(k) investor must make which is to determine what percentage of his or her retirement money should be allocated to each of the major classes of financial assets:  stocks, bonds, and cash.

Academic studies confirm that more than 90 percent of an investment portfolio's performance is determined by the asset-allocation decision.

Most of the major fund companies offer a family of life-cycle funds.  (IBM's funds are available only to participants in IBM's 401(k) plan).

If you want to add life-cycle funds to your 401(k) investment menu, keep these elements in mind.

Costs And Performance
The big mutual fund companies don't charge extra for their funds of funds because they invest solely within their own fund family.  You pay only the fees on the underlying funds.

You can buy independent funds of funds that are able to invest in any mutual fund from any fund company.

While that can be a valuable freedom, the independent funds of funds don't earn money on the underlying funds in which they invest.  As a consequence, they must levy their own charges, creating an extra layer of expenses for investors - typically about 1 percent of their portfolio per year.

That's an added hurdle to good performance, justifiable only if you believe that the independent fund of funds can generate better returns.

Benchmarks
When evaluating the performance of a fund of funds, be sure to use the appropriate benchmark.

Most funds of funds own a mix of stock and bond funds plus some money-market funds.   If you compare them with the most popular mutual fund benchmark, the Standard & Poor's 500 stock index, you'll never get a good handle on how well the fund is performing.

Insist that your plan provider supply participants with benchmarks that dovetail with your funds of funds.

Methodology
Some life-cycle funds invest in specific funds according to a fixed asset-allocation model - 40 percent in stock fund A; 40 percent in bond fund B, and so on.   Others, like Fidelity's, generally use the same funds but change the asset allocation mix as a target date approaches.  Still others, especially independent funds of funds, trade in and out of other individual funds opportunistically, the way a typical mutual fund trades in and out of stocks.

There's no right or wrong methodology, but understand what you're getting.   Conservative investors might prefer funds with a more rigid asset allocation discipline because it precludes attempts by the manager to "time the market" - a usually fruitless and expensive exercise.

"You want these funds to work for your employees and make them happy," concludes David Wray, president of the Profit Sharing/401(k) council of America in Chicago, an organization of plan sponsors and service providers.  "As a plan sponsor and fiduciary, you have to make sure everything is as it's represented to be."