Mutual Fund Basics: Asset Allocation Funds and Balanced Funds

I am starting an irregular Mutual Fund Basics series where I will discuss some basic concepts in mutual fund investing. Though I have a larger portion of my taxable investments in stocks than mutual funds, I feel I know mutual funds better than stocks (and yes, I am still learning). Actually, I already have a mini Understanding M* series that cover some gauges that Morningstar provides (so far risk measures, returns, and star rating have been discussed) to help us in mutual fund research. This series is for general discussions on subjects that I think could be helpful for new investors.

The first topic is this series is about asset allocation funds and balanced funds.

What they are

By definition, an asset allocation fund is a single fund that trys to achieve the desired asset allocation. Investorwords.com says an asset allocation fund

invests in a variety of securities in different asset classes. The purpose is to provide investors with truly diversified holdings and consistent returns, while sparing the investor the trouble of having to accomplish asset allocation by purchasing a large number of different funds.

This sounds a whole lot like a lifecyle (or targeted) fund, which also consists of various asset classes, with an obvious difference being that lifecycle fund is a fund of fund while asset allocation fund is a fund of securities.

A balanced fund, again from Investorwords.com, is a mutual fund

that buys a combination of common stock, preferred stock, bonds, and short-term bonds, to provide both income and capital appreciation while avoiding excessive risk. The purpose of balanced funds is to provide investors with a single mutual fund that combines both growth and income objectives, by investing in both stocks (for growth) and bonds (for income).

How they are different

While both funds mix stocks and bonds, their investment objectives are different: asset allocation funds seek broad diversification to achieve consistent returns and balanced funds maintain a fixed portion (or within a certain range) of stocks and bonds to provide both growth and income. For asset allocation funds, since the main goal is to achieve consistent returns, the allocation of assets within the fund changes from time to time, depending on the market conditions. For example, Vanguard Asset Allocation Fund (VAAPX) has 81.7% in stocks and 18.3% in cash at the end of 2006, according to Morningstar. However, the allocation changed to 100% stocks as of February 28, 2007. The annual yield of VAAPX is 1.99%. On the other hand, T. Rowe Price Balanced Fund (RPBAX) states its investment objective as the fund normally invests “approximately 60% of total assets in U.S. and foreign common stocks and 40% in fixed-income securities,” At the end of 2006, the fund has 64% in stocks and 36% in bonds and cash and its yield is at 2.40%. Since balanced funds always keep a portion of the investment in bonds, it’s understandable that the yield is higher than asset allocation funds which have much more flexible asset allocation.

Conclusions

Now we know the difference between asset allocation fund and balanced fund, which one should we choose? Well, the answer to this question depends on your investment objective. Though asset allocation funds try to be one-stop shop for investors who are looking for diversification, their holdings in each asset class change based on how the fund manager perceive the market conditions instead of investors’ goal. For balanced funds, though a certain fund has a certain target allocation in stocks and bonds, the allocation varies from fund to fund. For example, another popular balanced fund, Dodge and Cox Balanced Fund (DODBX), has a maximum stock holding of 75%. When choosing which fund to invest, we should always consider our investment objectives, our time frame, and our risk tolerance.

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