Lifecycle Funds

By Bob Wood, Muslim Media News Service (MMNS)

Last weekend, as I was skimming through the business section of my local paper, I saw an article about “Lifecycle Funds” by Jonathan Clements of the Wall Street Journal. According to Clements, these investments are all the rage, with assets soaring 61% in 2006. Most everyone must be buying them!

And what bigger red flag signaling danger is there than that one? I think the most popular investments are the most likely to disappoint over the long term, until they again become less popular, which brings them to proper pricing to allow for profits. When most everyone buys into something, no profit will be left to glean from it. Think back to technology stocks in the late 1990s, S&P 500 index funds in the early part of this decade, and housing in 2004 or 2005, when these investments were really hot.

In these cases, the crowd bids prices higher and higher, to the point where price premiums scare off anyone who hasn’t yet bought and too many are tempted to take profits. At some point, sellers begin to outnumber buyers by more than the margins can handle, and prices fall.

As bullish as I have been for the past few years on international and emerging markets stocks and mutual funds, I am becoming somewhat concerned at their current popularity with investors. For that reason, my enthusiasm has tempered for the short term, until a correction shakes out enough late comers to make buying them more attractive.

So how does this pattern affect the “lifecycle funds” discussed in the Clements article? Such funds are actually akin to a “fund of funds” hedge fund, in that their holdings often consist of a basket of existing mutual funds sold by the same fund company and offering the”lifecycle” option.

At first glance, the lifecycle fund approach appears to be just another way to package and sell existing mutual funds. After all, the financial services industry is the greatest sales and marketing enterprise ever invented. As in any industry, product developers either announce new and better products, or marketing teams find clever ways to package and sell the same old things. The appeals of lifecycle funds include simplicity and the ability for owners to adjust risk exposure downward as they get older.

So the need for annual rebalancing disappears, since the fund company does that for you. As Clements explains, “These funds were designed to be the ultimate buy-and-forget investment. The notion: You buy a lifecycle fund that targets your expected retirement date, and then sit back and let your money ride all the way to retirement and beyond.’’

So how do they work? Let’s examine some options from one of the better domestic fund companies, T. Rowe Price. If you are nearing retirement in the next few years, you might choose to invest in the “Retirement 2010” mutual fund. With it, you get the classic 60% allocation in stocks, with nearly 20% of the stock allocation invested in international stocks. About 32% of the fund invests in bonds with the rest remaining in cash. Of course, the actual holdings of this fund are shares in existing T. Rowe Price funds, such as its S&P 500 Index fund, Growth Stock Fund and several bond funds of differing maturities and risk ratings.

If you had retired in 2005 and previously chosen the “Retirement 2005” fund option, your fund allocated only 51% of your investment in stocks, just over 40% in bonds and about 6% in cash. This difference shows how the fund with the longer maturity will shift holdings in the coming years.

So far, I’m sure this investment approach appeals to most readers. Doesn’t this the kind of investment make sense as we get older? Once we retire, we most likely will not have discretionary money left each month to add to our savings. So reducing our exposure to downside risk seems prudent, since, if the markets fall while we’re using investment money for living expenses, we could really suffer financially.

Perhaps another reason for companies offering these investment options is how easy they must be to sell. Maybe how they ultimately perform for buyers could be secondary to how they work for the sellers in the short run.
Now that we’ve looked at some of the positive selling points such as the simplicity of having the fund company rebalance the fund each year, thus automatically reducing your risk exposure, and enabling you to ‘’buy and forget,’’ let’s explore some potential downside risks. First, reducing risk goes hand in hand with reducing performance, doesn’t it? While the fund becomes less exposed to downside risk as the owner ages, it also becomes less exposed to upside potential. That’s only fair, right? But what owners will never escape as they age is the risk of inflation making their cost of living rise faster than expected. And don’t we seem to become more acutely aware of rising prices as we get older?

The other risk exposure left unaddressed is the potential for living longer than expected. Sure, the actuarial tables issued by the insurance industry are good for estimating life expectancy, but how many men will live past age 87? That possibility seems to become more common, yet what attention is given to individual situations as some may have more reason than others to expect a longer life based on health factors or family history? What if you had been taking monthly withdrawals and getting mid single digit investment gains for longer than was expected?

Another problem may be the heavy allocation to domestic markets. Yes, I’m bearish on domestic markets and see little upside potential over the next 10 to 20 years. In the past, such allocations would have worked just fine. But that was then, and this is now. Times change, and yesterday’s returns are no guaranty of future performance.
What we see today are domestic stocks and bonds selling at premium prices. And many calculations done by my fellow Bears indicate that future performance is bound to fall due to the high prices paid for stocks and bonds and the historically low-dividend payouts from both asset classes.

So lifecycle funds violate two of my most strongly held beliefs about investing: if it’s popular, there is no money in it, and if it’s easy, there is even less money to be made. These lifecycle funds offer both: popularity and ease.
In my thinking, no room exists in any portfolio for domestic bonds of any maturity. Where is the wisdom of owning what pays about 5%/year in dividends in an inflationary environment where current prices for basic commodities like oil, gas and food are rising close to 8%/year? And with the U.S. money supply increasing at record rates, what is the outlook for inflation as we get older? Since health care costs are also rising fast, getting better returns, similar to those of still-working younger persons, seems only prudent.

So maybe we can do a better job of building our own lifecycle funds! We can start by investing in those things that we fear may rise in price faster than expected. What about energy? What better feeling can we have, when gasoline prices rise above $3/gallon – perhaps on their way to $4, than having a nice chunk of savings invested in that rising commodity or that the companies will profit from those rising prices. What are your expectations for energy prices over the next 10 or 20 years?

Some other good inflation hedges are gold and other precious metals. If we worry about rising prices or the continued loss in purchasing power of dollars in our savings accounts, let’s add a nice helping of a good precious metals fund. Very little, if any, exposure to these asset classes appears in the ‘’buy and forget’’ variety of lifecycle funds.

In addition, health care costs are sure to rise strongly in the future. But that market sector has been too popular with the crowd and professional investors for the past few years, so few bargains exist there. So, for now, I’d pass on those.

Some investors, depending on personal beliefs, may want to include an allocation in bond funds to help mitigate expected volatility. I find that international bonds are far better options now. My favorites include closed-end funds, which sell at nice discounts to their underlying portfolio’s value, since investors don’t know much about them and they are not heavily marketed. Consider AWF and ESD. I own shares of both, so consider that fair disclosure warning.

Everyone needs stock exposure for added growth potential, but the pickings are getting rather slim. Excess money printing around the world has found its way into all types of stocks and stock markets. Many markets sell at premiums, but, due to investor misperceptions about risk, several options still look far better than our domestic markets. A nice basket of international and emerging markets funds can work nicely, and we can include less of them, due to their higher performance potential, thus reducing stock exposure if risk is a concern.

While the short-run looks rather precarious, in my opinion, over the longer term this is where the best returns will be found. We can start with smaller allocations and patiently wait for a better time to load up.

This version of a lifecycle fund is not as simple or carefree as those heavily-marketed varieties. You would need to rebalance your portfolio yourself, but probably no more than once every two or three years.

But if targeting retirement expenses is more important than accepting retirement volatility, I think this plan makes a lot more sense. Retirement costs much more than we think it will before we get there. Ask anyone who has already made the transition to the “leisure set.” As economic power and growth shift to other places around the world and as jobs shift to those places, allow your stock exposure to follow.

Do a little work now to build your own lifecycle fund, for yourself, who you are as an investor and how long you might reasonably expect to live. Think about keeping a higher exposure to risk and returns since you may live longer than most and might want to leave more behind for your heirs. I think a more individual approach makes more sense than one designed for the “average person.”

Have a great week.

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc.,


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