Keeping It Simple

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Keeping It Simple
by the Schwab Center for Financial Research
March 3, 2009

Many investors crave simplicity. Fund companies have responded with gusto, developing a dizzying array of single-solution portfolios offering professional management and easy asset-class diversification, in hopes of generating compelling returns. But choosing among them isn't easy. Here we analyze the three major types of "simple solutions" to help you determine which might be a good fit for you.

Lifestyle funds: if you know your style
This is where the single-investment idea began. Originally referred to as balanced funds, lifestyle funds are now more commonly called aggressive, moderate or conservative allocation funds, as they have evolved to correspond to investors' risk profiles. The asset allocation (mix of stocks, bonds and cash) is typically kept within a set range.

Lifestyle funds can be terrific single investments if you believe your appetite for risk will stay the same for a while. Perhaps you're younger, just beginning to build an investment portfolio and expect to have an aggressive allocation for some time, or you're retired and want to stick with a conservative allocation. But before you pick a fund, take these three steps:

Check a fund's allocation to stocks. Even within moderate allocation funds, stock percentages can differ dramatically. Stocks are the primary driver of risk and growth potential, so be sure that this allocation is aligned with your risk tolerance and goals.
Compare performance "apples to apples." Past returns are heavily influenced by a fund's stock exposure. For example, lifestyle funds with higher stock allocations generally outperformed funds with lower stock allocations over the last three years (excluding the current recession) because the stock market was up during that time.
Look for a low expense ratio. That's the fund's annual operating expenses as a percentage of assets. As expense ratios have been trending lower, one above 1.25% should raise questions.

Target date funds: if you know when you'll retire
If you have a good idea when you will begin making withdrawals, it's pretty tough to go wrong finding a target (also called lifecycle or age-based) fund within your time horizon. Choose a fund with a target date within a couple of years of the beginning of your retirement spending (e.g., 2020), make sure the expense ratio and asset allocation are reasonable and then let the portfolio managers do the heavy lifting. Target funds typically have a "fund of funds" structure: Managers monitor asset allocation and overlap between investment styles, but leave daily investment decisions within each style to the underlying funds, usually within the same fund company.

Unlike lifestyle funds, the asset allocation generally shifts from an aggressive tilt (more stocks) to a more conservative tilt (more cash and bonds) over time. Not surprisingly, these have become a very popular option for many 401(k) plans, as investors target a specific time period for retirement. Here are a few pitfalls to watch out for:

Target dates are for retirement, not houses. These funds are typically designed to deliver retirement income and will still include stocks in their portfolio at their target date—for portfolio growth during retirement. So if your goal is making a down payment on a house in six years, you will want to consider a short-term bond fund, not a target 2015 fund.
Simple solutions should stay simple. Pairing a target fund with another mutual fund can drastically shift your portfolio's risk level.

Mutual fund wraps: for customization and top manager selection
If you want a fund solution customized to your risk profile and tax situation, consider a wrap account. So named because investment services are "wrapped" together for a single fee, wraps were initially designed for wealthy and institutional investors. But investment minimums and fees have now fallen, which broadens their appeal.

Like lifestyle funds, wrap asset allocations are designed to generally stay constant over time. Wrap managers build a portfolio of mutual funds to a particular risk portfolio. The managers then monitor the portfolio, and can quickly replace a fund if its performance prospects deteriorate or if there are any alarming changes to the management team or investment philosophy. Here are a few benefits of wraps:

Tax-sensitive decisions. If you buy a mutual fund in November, you may get distributions in December on the whole year's gains in the event any are distributed. Wraps can make more tax-friendly decisions. For example, clients who begin to invest in Schwab Managed Portfolios in November may be first invested in exchange-traded funds (ETFs) to avoid December capital gains payouts. They also rebalance at least one day after your anniversary date to avoid short-term gains—unlike target and lifestyle funds, which use the same date for all investors.
Using the right tools for each job. Since the Schwab mutual fund wrap program picks the managers Schwab believes are best for each style and would be a good fit for the particular model, you never have to rely on a great equity fund company for your bond funds.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost. Past results are not a guarantee of future performance.

Approximately 2,100 funds participate in the Mutual Fund OneSource® service. Only these funds, including Schwab Affiliate Funds, are analyzed and eligible to be considered for inclusion in Schwab products, including Schwab Managed Portfolios. Schwab receives remuneration from fund companies, and/or their affiliates, in these products for recordkeeping, shareholder services and other administrative services.

Please read Schwab's Schedule H of Form ADV for important information and disclosures relating to Schwab Managed Portfolios.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should pursue any particular investment strategy. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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