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“Set It and Forget It” Funds in Focus

Imagine the following hypothetical situation…

Tomorrow, you’re going to fall into a coma that will last five years.

You’re allowed to invest in one, and only one, investment for the duration of your coma.

Which investment would you pick?

Some might select a Dividend Aristocrat such as McDonald’s (MCD)… and turn on dividend reinvestment, of course.

Others would desire better diversification and go with the SPDR S&P 500 ETF Trust (SPY).

More conservative investors might want the safety of a 5-year Treasury bond, since they’ll know exactly how much money they’ll wind up with once they arise from their comas.

However, none of these investments benefit from asset class diversification.

For an all-in-one investment solution, we’ll need a more strategic approach…

Balanced Funds

A balanced fund – also known as an asset allocation fund – holds multiple asset classes, such as equities and fixed income.

The oldest balanced mutual fund is the Vanguard Wellington Fund (VWELX), which has been in existence since 1929. Boy, has it seen everything!

The fund, which is run by seasoned investment professionals from Wellington Management Company, invests 60% to 70% of its assets in mid- and large-cap stocks. It holds value stocks that predominantly pay a dividend.

The remaining 30% to 40% of the fund is invested mainly in investment-grade corporate bonds, with some exposure to Treasuries and mortgage-backed securities.

The fund can invest up to 25% of its total assets in foreign stocks and bonds.

Although its strategy has shifted a few times, VWELX has an 8.3% annualized return since inception – an impressive feat for a fund with a fixed-income component.

The fund’s recent performance has been nothing short of phenomenal.

Over the past 10 years, VWELX has provided 109% of the return of the S&P 500 Index – but only 66% of the risk (volatility).

This type of risk-reward ratio illustrates the benefits of broad diversification, periodic rebalancing and astute management.

The annual fee for VWELX is just 0.26% per year (0.18% for the Admiral Shares, which requires a minimum investment of $50,000), and its yield is 2.2%.

The Vanguard Wellington Fund truly lives up to the balanced fund moniker by providing a nice mix of current income and capital appreciation, while keeping capital preservation a top priority.

Granted, a five-year coma may be outlandish. But the reality is that many people crave simple investments that they don’t have to watch on a day-to-day basis. They want to “set it and forget it,” so to speak.

But to be truly hands off, an investment needs to become less risky as time progresses.

Glide Path to Retirement

In 1993, BlackRock pioneered what’s known as a target-date fund.

This specialized type of balanced fund automatically reduces the equity exposure and increases the bond exposure as you get closer to your proposed retirement year.

Fidelity, T. Rowe Price and Vanguard are the dominant asset managers in this category.

And target-date funds are, indeed, becoming very popular…

According to Morningstar, assets held in target-date mutual funds have more than quadrupled since 2008, to over $650 billion. Vanguard, the largest manager of defined-contribution assets, estimates that 58% of its plan participants and 80% of new plan entrants will be entirely in target-date retirement funds or comparable investments by 2018.

Currently, the largest target-date fund is the Vanguard Target Retirement 2025 (VTTVX), which holds Vanguard total stock market and total bond market passive index funds. This enables it to keep fees at just 0.17%.

The Fidelity Freedom 2025 Fund (FFTWX), on the other hand, employs a slightly different approach. It holds a wide array of Fidelity actively managed mutual funds, but fees are much higher at 0.72% per year.

One of the primary criticisms of these target-date funds is their tendency to hold relatively high equity allocations in the years directly leading up to the retirement date. This proved to be quite stomach churning during the credit crisis.

For example, the Vanguard Target Retirement 2015 (VTXVX) experienced a drawdown (peak-to-trough decline in value) of 42% from October 2007 to March 2009. Still, the fund has rewarded near-retirees with the fortitude to set it and really forget it, as it has more than recovered and posted an 11.9% average annual return over the past five years.

In general, balanced funds and target-date funds would certainly benefit the vast majority of retail investors. As I recently relayed, the average investor has only compounded 2.5% over the past 20 years. This is simply inexcusable, especially with stellar offerings like the Vanguard Wellington Fund out there.

Later this week, I’ll discuss another related trend in investment management – robo-advisors.

Safe (and high-yield) investing,

Alan Gula, CFA