Below are some of the most frequently misunderstood issues:
Target-date funds may look alike, but they behave in different ways
Target-date funds are designed to act like a financial planner for your portfolio. People who are many years from retirement may have a high percentage of their assets in the stock market. Gradually, as people get older, the funds shift their allocations toward more bonds and cash. How the funds do this varies widely. Some funds focus on longevity risk and tend to be more heavily invested in stocks throughout their “glide paths.” Others focus on volatility risk and are likely to be more conservative. Some funds end their glide paths at or near age 65. Other glide paths last much longer—to age 80 or older. The right fund for your participants will depend on their demographic profiles, risk tolerance and other behaviors.
Your fixed account may not be fixed, and it may contain assets other than bonds
Here are some questions you need to ask about your account: How often does the interest rate reset? How much risk does your fixed or stable value fund take? How strong is the rating of the guarantor? Does the fund contain just bonds and cash, or does it also include stocks and commodities? How does it use derivatives? The answers to these questions will help you understand the fund’s composition, as well as the extent of its exposure to interest and credit volatility. That understanding will guide you in determining its suitability for your participants.
A change in manager does not always matterNot all funds are managed similarly. Some funds employ a “star manager” who makes all the decisions about what to buy and sell. Other funds make their decisions collectively in teams. Managers come and go. If a star manager leaves a fund, it could signify trouble. But if one member of a large team leaves, it may not significantly affect performance.
Not all index funds are alike
One S&P 500 index fund normally looks just like any other. But that does not apply to foreign index funds. Some indexes just include developed markets (MSCI EAFE), while others incorporate as much of the globe as they can (FTSE All-World ex-US). Once you have analyzed a particular index, you will want to know how well the fund tracks it. Funds do not usually buy every stock in an index; instead, they use statistical sampling techniques to approximate it. Some funds achieve this goal better than others. Index funds also fall into many different cost brackets. So here are the questions to ask about an index fund: What exactly does it track? How well does it do so? How much does it cost?
Style drift is not always a serious problem
If you have three large cap U.S. stock funds in your portfolio, (for example: value, blend and growth), you should care about style drift because you do not want them to overlap too much. But if you have one small cap U.S. stock fund, drift is not very important. And that is fortunate, because small cap stock funds tend to drift quite a bit.
Asset allocation between stock and bond funds is what matters most
Because some investors will look at an array of 20 funds and decide to put 5% in each, having a reasonable balance between stock and bond funds in the plan may help protect those investors from themselves. They will end up building a diversified portfolio without even knowing it.
The number of funds matters tooIf you are a sophisticated investor, the more fund options in the plan, the better. But the vast majority of investors find too much choice daunting. For them, fewer funds mean less confusion.
Correlation is the enemy
If two funds move up and down at the same time in response to market conditions, they are said to be highly correlated. Correlation in investments exposes a portfolio to added risk when all its positions move in the same direction. If your funds react in different directions to the financial environment no matter what happens, part of your portfolio will always be performing. Low correlation means more diversification.
Most stock funds respond to the markets in very similar ways
Over the past few years, stock funds have become much more highly correlated. Most funds fell together in 2007 and 2008, and began to recover together in 2009, whether they were large, mid or small cap, U.S. or foreign. If your portfolio contains many stock funds, you might not be as diversified as you think.
Bond funds are less alike than stock funds
Bond funds, on the other hand, have lower correlations. Bond funds may have significant differences in credit quality. U.S. Treasuries did well during the recession because they carry the highest credit rating. High yield bonds did poorly because of the low credit quality of the underlying companies that were issuing the debt, which made them more sensitive to economic conditions. Bond fund performance can also depend on the average maturity or duration of the portfolio. Short and long maturity portfolios can exhibit vastly different performance results, due to interest rate changes and shifts in the shape of the yield curve. These differences reduce correlations and argue for holding a variety of bond funds in your lineup.
—Paula Boyer Kennedy, MBA, CPA, PFS, CFP®, CIMA®, AIF®, Vice President, Investment Services, Cammack LaRhette Consulting
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.