An asset allocation fund invests in a mix of asset classes, like stocks and bonds, in fixed percentages. It provides built-in diversification to investors. They can make it easier for the investor to maintain a portfolio. Read on to discover if an asset allocation fund can help you achieve your financial goals.
An Asset Allocation Fund Explained
An asset allocation fund is a portfolio including a diversified mix of asset classes. As a result, investors can choose between a fixed or variable asset allocation fund which has a variety of security categories. Funds may have fixed weight asset class percentages that may not exceed a certain amount in various market conditions. Consequently, asset allocation funds may use asset categories including stocks, bonds, and cash equivalents.
All funds use modern portfolio theory to model their allocations. This theory states that investors can achieve optimal returns by investing in a diversified portfolio. All the investments that this strategy includes must be a part of the efficient frontier. This theory also helps guide investors in selecting securities that suit their risk tolerance.
Types of Asset Allocation Fund
There are several applications of asset allocation funds. One of the most common applications is a balanced fund. With this model, investors use a balanced allocation of equities and fixed-income securities. For example, the investor may choose to invest in 60% stocks and 40% bonds. Using a 60/40 split of assets has become a popular investment strategy among investors seeking diversification. But if investors want to find an asset allocation fund that has a different level of risk, they may prefer a fund with conservative or aggressive allocation.
Investors can also choose dynamic asset allocation funds. With these funds, the portfolios don’t have certain weight restrictions like balanced funds do. Dynamic asset allocation funds offer more flexibility. For instance, these funds may solely invest in either equities or debt. These funds modify their portfolios based on quantitative models. These models determine the value of the different asset classes in the portfolio.
For example, if the model signifies that a price-to-earnings over 20 is expensive, then the fund may invest only in bonds instead of equities if the equities surpass the metric. Or, if the P/E dips below 10 on equities the fund may increase the weight on the equity investments.
Dynamic funds can also help retirement planning. Consider looking for dynamic funds such as life-cycle funds or target-date funds. With this type of fund, asset allocation can change based on the time horizon of the investor. Usually, target-date funds will start with a riskier allocation and transition to a more conservative allocation as the target date approaches, such as retirement.
How to Choose an Asset Allocation Fund
Each asset allocation fund may hold a different exposure to stocks and bonds. For example, the iShares Core Aggressive Allocation ETF (AOA) tries duplicating the performance of the S&P Target Risk Aggressive Index (heavily weighted toward equities). Meanwhile, the iShares Core Conservative Allocation ETF (AOK) aims to duplicate the S&P Target Risk Conservative Index (heavily weighted toward fixed-income).
Selecting a fund will start with you understanding your own risk tolerance, time horizon, and financial goals. Since equities are deemed more volatile than bonds, the iShares Core Conservative Allocation ETF (AOK) may be a better fit for someone who is getting close to retirement. However, the iShares Core Aggressive Allocation ETF (AOA) may be a good fit for someone just starting their career and seeking a few decades of portfolio growth.
Consider selecting the asset allocation fund that you believe best meets your financial needs. If you’re unsure which fund makes sense for your financial plan, you may want to partner with a financial advisor who can guide you in making the best decision.
The Bottom Line
Asset allocation funds are funds that help investors diversify their portfolios. Investors should select funds based on their risk tolerance. There are several asset allocation funds, therefore your financial goals and stage in life will determine which one is right for you. If you’re unsure if these funds are right for you, consider consulting an advisor.
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- Consider capital gains taxes when you’re thinking about how much money you’ll make from your investments. SmartAsset’s capital gains tax calculator can help you figure out how taxes will impact the money you make from selling stocks.
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