Asset allocation funds aim to improve returns and/or reduce risk by switching back and forth among stocks, bonds and cash. We think they are likely to hurt your portfolio returns rather than enhance them.

Asset allocation funds are mutual funds whose managers believe they can improve returns and/or reduce risk by switching back and forth among stocks, bonds and cash. Unlike balanced funds, they can shift their portfolio allocations between stocks, bonds and cash in order to capitalize on perceived investment opportunities in any one of those classes.

If a fund’s name includes the term “asset allocation,” it means the fund’s managers, or sponsors, feel that they can enhance returns and/or reduce risk by switching back and forth among stocks, bonds and cash equivalents, often using a so-called “black box”—a computer program that makes trading decisions based on a pre-selected set of rules for interpreting financial statistics.

For example, if the managers feel that the bond market is depressed and poised for an upswing, they may overweight the portfolio in fixed-income investments for a few months to take advantage of the change. Adding computer modelling makes this investment approach sound even more scientific, but it is just as likely to detract from a portfolio’s long-term returns as it is to add to it.

Asset allocation is overrated as an investment tool. Asset-allocation strategies rose to prominence because the investment industry seized on some academic research on the subject and turned it into a sales pitch for investment products that carry much higher fees than regular stocks and bonds.

To understand why, apply the “reductio ad absurdum” test. If fund managers could make 10% to 20% a few times a year on well-timed trades, they could probably earn, say, 50% a year for investors. That rate of return would turn $10,000 into $33 million in 20 years, without any additional contributions. Lots of people had $10,000 to invest 20 years ago; few have $33 million today.

Asset allocation funds are like hindsight—they work great when applied to the past, since their creators can tweak the rules to match what actually happened. Asset allocation funds are far less effective at forecasting the future. However, asset allocation funds are always great at jacking up a fund’s expenses, because of the commission’s their trading generates. The MER (management expense ratio) that such funds charge can hurt your returns.

Here are 5 profit-killing risks that asset allocation funds expose you to:

1. Market timing risk: As we mentioned, asset allocation fund managers try to outperform the market by betting on relatively short-term trends, rather than putting their investors in a position to profit from long-term economic growth. In any one year, the top fund is often run by a market timer who is having his or her proverbial “day in the sun.” However, in any one decade, the top funds are run by conservative managers who focus on long-term growth in the economy.
2. Bond risk: The performance of bonds is inversely related to the rise and fall of interest rates; when rates fall, bond prices go up. The opposite is true when rates rise. With rates at historic lows, bond prices can’t go a lot higher than they are. In fact, it seems more likely that rates will continue to hold steady or rise in the near term, and move higher in the long run. That means funds would only earn interest income on their bonds; instead of capital gains, their bond holdings could produce capital losses.
3. Heavy reliance on computer modelling: Asset allocation fund managers often use a so-called “black box”—a computer program that makes trading decisions based on a pre-selected set of rules for interpreting financial statistics. While this approach sounds scientific, it is just as likely to detract from a portfolio’s long-term return as it is to add to it.

Computerized asset allocation programs are like hindsight—they work great when applied to the past, since their creators can tweak the rules to match what actually happened. They’re less effective at forecasting the future. However, they are always great at pushing up a fund’s expenses because of the commission’s their trading generates. The management expense ratio that such funds charge can hurt your returns.

4. Avoid mutual fund managers who trade heavily: Asset allocation fund managers believe in frequent trading. Many of these managers fail to realize how close their mutual fund’s performance comes to disaster each year, until disaster finally strikes.

If you add up a heavy trader’s losses at the end of a given year, they may amount to a high percentage of their fund’s assets (25%, for example). That may seem perfectly acceptable to the mutual fund manager, so long as the profits on their winning trades are significantly higher than that (for example, 75% of assets).

If the mutual fund manager guesses wrong a few times, however, it’s all too easy to reverse those figures: that is, have losses totalling 75% of assets and profits totalling 25%, so that the mutual fund loses 50% of its capital. If the manager delves into low-quality or highly volatile choices, as heavy traders are apt to do, then the mutual fund’s performance can drop.

5. Beware of buying vaguely described mutual funds: Are you unsure of an asset allocation funds portfolio? Does the sales literature seem different than what is advertised?

It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. Many mutual fund operators describe their investing style in vague terms.  We always take a close look at a mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. When the mutual fund takes on a lot more risk than you’d expect, our advice is to get out.

Are you invested in any asset allocation funds? Has it been a profitable? Share your experience with us in the comments.