After the extreme volatility in various financial markets over the past two and a half years, many investors are looking for mutual funds that don't require them to put all their eggs in one basket, such as stocks. Asset allocation funds, which invest in more than one financial market at a time, can provide you that diversity.
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"These are very appropriate for the average investor because it gives you diversity and risk management, which are difficult things for most people to do on their own," says Michael Dixon, director of wealth management for Carl Domino Inc., financial advisers in Palm Beach, Florida.
The most basic form of an asset allocation fund is a balanced fund. These funds go back about 70 years and are balanced between stocks and bonds.
Traditionally, the allocation was about 60 percent stocks, 40 percent bonds and was fixed. Now the funds come in an array of different allocation percentages, and some funds even shift their percentages from time to time according to market conditions.
Over time, the funds have diversified. "Rather than just having large-cap stocks and high-grade bonds, they've gone to a broader mix of equities, bonds and cash," says Greg Carlson, a mutual fund analyst at Morningstar research firm in Chicago.
"Now there will be a broader mix of equity, bonds and cash. Often it will be a fund of funds, including large-cap stocks, small-cap stocks, foreign stocks, high-grade bonds and junk bonds."
And in the latest evolution of asset allocation funds, they have turned to alternative asset classes, such as commodities, real estate and currencies.
"There are a number of new funds over the last 12 to 24 months that provide a combination of asset classes that previously weren't available as a package," says Michael Sheldon, chief market strategist for RDM Financial Group in Westport, Connecticut.
"If you believe interest rates and inflation will rise, for example, there are funds that invest in a combination of TIPS (Treasury inflation-protected securities), real estate, commodities, floating-rate debt and other securities."
One of Sheldon's favorite funds invests in domestic and foreign stocks, domestic and foreign bonds and, to a small extent, in gold. "The goal is global diversification with moderate risk," Sheldon says.
Here are five important questions to ask yourself when considering an investment in asset allocation funds.
1. Do you want to invest in them at all?
Not everyone believes in these funds. If the allocation percentages of the fund are fixed, you may be unhappy in certain market environments.
"Too often the funds have 60 percent or more of their assets in stocks," says Michael Heyman, an independent financial adviser in San Diego. "When things are going OK in the stock market, it works. But the moment something goes wrong, you're worried that you have too much in stocks."
And your worries don't end by choosing a fund that shifts its allocations, he says. "If it's not a passive fund, then you're really just betting on the manager. The problem of doing that in a mutual fund is you don't really get an insight on who that manager is. And for all the managers who are successful, there are a million horror stories."
2. How big a return do you seek and how much risk you can you stomach?
If you are risk averse, consider a fund that is weighted more heavily toward U.S. government or high-grade corporate bonds. If you're looking to maximize your returns and can handle the elevated risk of trying to achieve high returns, consider a fund more weighted to stocks, including small-cap and foreign equities.
3. Do you want a fund with static allocations or one that shifts according to market trends?
"We like passively managed funds," says David Cowles, director of investments for financial advisers Mosaic Financial Partners in San Francisco. "For example, if a fund decides to sell international stocks for 12 months, that's market timing, which we don't like."
But others feel differently. "The ability of the team to shift its portfolio weightings based on the economic environment is positive for investors," Sheldon says.
In either case, of course, you want to research the fund manager thoroughly -- from his or her track record for returns to his/her investment philosophy.
"There's a little more risk on making the right call for the active managers," Carlson says. "So you want to understand the asset allocation process and how that fits into what you're doing."
4. How broad a range of assets do you want your fund to include?
Many advisers say the broader, the better. "The benefit of a multi-asset fund is that you get diversification in one fund as opposed to having to make multiple securities choices," Sheldon says.
5. How much are you willing to pay in fees?
For funds that are oriented toward domestic stocks and bonds, advisers say you should be able to find a strong performer with fees totaling about 1 percent or less.
Copyright 2014, Bankrate Inc.