Are Life-Cycle Funds Right for You?

Mutual funds are a great way to diversify risk and achieve healthy gains. But plenty of people don't have the time or inclination to research individual mutual funds. Instead they buy so-called asset allocation funds. Managers of these funds are constantly looking to maximize returns and attempt to do so by moving money in and out of stocks, bonds and cash (meaning short-term, high quality debt).

The problem with asset allocation funds is that they can be a lot riskier than you think. The wide discretion money managers have with these funds allows them to load up on, say, high tech stocks or Latin American bonds. At times these are the best investments around. At other times, they are real dogs.

Investors looking for more peace of mind may want to consider life-cycle funds instead. Life-cycle funds are like asset-allocation funds in that they buy stocks, bonds and cash. But they are different in that they try to maintain their original asset weightings. If a money manager of a life-cycle fund is bullish on bonds, for example, she or he will only boost the weighting of bonds as a percentage of the portfolio from, say, 40 percent to 45 percent of the portfolio. In the same circumstance, a typical asset allocation manager may boost the weighting to 60 percent from 40 percent.

Fund managers also pare their portfolio to reflect the original asset allocation. In a life-cycle fund for older investors, for example, the fund may invest 80 percent of its assets in bonds, 10 percent in stock and 10 percent in cash. Because stocks usually have a higher rate of return, the manager will sell off some of her stock once the value of the stock starts to represent, say, 13 percent of the portfolio.

But life-cycle funds aren't for everybody. First, make sure that the fund manager of the life-cycle fund is constrained from risky behavior. Check the prospectus to make sure she or he can't invest the majority of assets in any one particular type of security.

Next, make sure that the life-cycle fund you invest in is right for you. If you're 80, financially well off but not very risk averse, you may want to consider a life-cycle fund that's geared for younger investors, which usually hold a higher percentage of stock.

Look at the expense ratios of life-cycle funds. They are usually more expensive than regular mutual funds. For example, many life-cycle funds charge 1.2 percent of annual assets while most bond index funds charge 0.5 percent a year or less. The idea here is to create your own life-cycle fund by buying, say, one stock index fund, one bond index fund and one money market fund. The annual expenses of the three separate funds are likely be far less than the expenses of the life-cycle fund and the performance is likely to be just as good.

Bottom line: like most do-it-yourself projects, creating your own life-cycle fund is cheaper but more time consuming than having someone else do it. Among the least expensive life-cycle funds are those offered by Vanguard and T. Rowe Price.

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