Has Your Moderate-Allocation Fund Turned Aggressive?

Morningstar

Unless you've been living under a rock, you probably know that interest rates have been kept well below their historical norms for years by the Federal Reserve in an effort to stimulate the economy in the wake of the Great Recession that began in late 2007. This situation presents a conundrum for moderate-allocation funds, which invest 50% to 70% of their assets in stocks and historically have stashed much of the rest in government bonds. While equities are typically more attractive in a low-rate environment, owning more of them tends to goose volatility, and these funds are often marketed to relatively risk-averse investors. On the other hand, low yields often make rate-sensitive bonds more risky, as Treasury bonds' swoon in the summer of 2013 illustrated: From May 1 through Aug. 16, while the yield on the 10-year Treasury bond rose from 1.6% to more than 2.8%, the typical intermediate-bond fund lost 4.4%. Meanwhile, the S&P 500 gained 4.4% during that span.

Moderate-allocation funds have generally responded by owning more equities. At the end of February 2009, just before the end of the bear market, the typical moderate-allocation fund invested 55.3% of its assets in stocks. By the end of November 2013, that figure had crept up to 60.2%. True, that matches the weighting of the classic balanced fund (60% stocks/40% bonds), but the category contains many other offerings. And given that the equity stakes of moderate-allocation funds, as defined by Morningstar, fall in a fairly narrow 20-percentage-point range, that increase is significant.

Some of our favorite moderate-allocation funds have gone a step or two further in recent years, stashing much more in equities than that rising category median. Will they continue to do so? Let's take a closer look.

Dodge & Cox Balanced (DODBX)
Dodge & Cox has a conservative reputation, but this fund is no shrinking violet. While its neutral stance is 60% stocks/40% bonds, the fund maintained a 70% to 75% stake in equities for much of a four-year span (mid-2009 to mid-2013). That's highly unusual here; the fund's equity stake hadn't consistently been that high since the late 1970s.

The fund's management team, which typically holds a big slug of corporate bonds in the fixed-income portfolio (including the debt of some firms also owned in the equity sleeve), found much more value in equities given their valuations and bonds' low yields for much of that span. That was the right call; the fund outpaced 95% of peers for the five years ended Dec. 9, 2013. The team has recently pared back its equity exposure to 68% because of rising valuations and the rise in interest rates over the summer, and expects that weighting to remain below 70% unless valuations improve significantly.

Fidelity Puritan (FPURX)
This fund's portfolio typically has reflected a bullish look on equities since Ramin Arani became the lead skipper in 2008, often holding 60% to 65% of assets in stocks. But Arani has opted for a bolder look lately, as the equity stake has ranged from 67% to 74% of assets since October 2012. The result has been top-quintile returns over three and five years through Dec. 9, 2013. And savvy security selection by both Arani (who oversees the equity portfolio) and Fidelity's fixed-income team helped the fund hold up reasonably well in 2011's choppy market. Thus, the fund's risk scores are average versus peers despite the added dose of stocks. Given its success and Arani's history here, expect the recently elevated equity stake to remain for now.

Invesco Equity and Income (ACEIX)
This fund typically invests around 60% of its assets in stocks, and will also own a double-digit stake in convertible bonds (which can be pretty sensitive to equity markets, thus Morningstar counts half a fund's converts weighting toward its equity exposure when assigning a fund to a category). Its equity stake has risen as high as 68.5% in recent years, in part because the managers have found fewer attractive converts to buy. The fund's weightings in corporate and Treasury bonds have shrunk, too, however.

Management's moves have paid off, as Invesco Equity and Income has beaten most moderate-allocation funds over the past five years. Its ongoing above-average equity-market exposure has resulted in a move to the aggressive-allocation category.

Oakmark Equity & Income (OAKBX)
This fund's equity weighting has ranged widely in recent years. It sank as low as 48% of assets in late 2008, but has been no lower than 66% since the end of 2010--and climbed to 75% in mid-2013. To an extent, the size of the fund's stake in stocks has been influenced by the varying fortunes of its bond portfolio over that stretch--the fund heavily favors U.S. government debt, which is more sensitive to interest-rate swings than most other types of bonds.

Lead skipper Clyde McGregor largely determines the fund's equity weighting, though, by judging the attractiveness of equities versus bonds. And while he has often made the right calls lately on this front, uncharacteristically spotty stock selection dented returns in 2009, 2010, and 2012, resulting in a weak five-year record compared with both the moderate-allocation category and the fund's new home, aggressive allocation. McGregor is likely to continue limiting the fund's bond exposure as long as rates stay low.

Greg Carlson does not own shares in any of the securities mentioned above.

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