Actively managed global allocation funds are designed to add value by shifting between asset classes and geographical regions based on the fund manager’s outlook for market conditions – they tactically allocate. Their marketing pitch is that skilled investment managers can produce a superior rate of return compared to traditional index funds. But the reality does not match the hype.
Srinidhi Kanuri and Davinder Malhotra, authors of the study “Evaluating the Performance of World Allocation Funds,” published in the Spring 2022 issue of The Journal of Wealth Management, analyzed the risk-adjusted performance of world allocation mutual funds over the period January 1994-March 2021 (including dead funds to avoid survivorship bias). They compared the performance of world allocation funds to the U.S. stock market (Russell 3000 Index), the U.S. bond market (Barclays Aggregate Bond Index) and the foreign stock market (FTSE All World Ex US Index). In addition, to check the robustness of their results, they formed three different portfolios to control for differences in the risk profile of world allocation fund investors:
- Portfolio I: 50% Russell 3000/50% Barclays US Aggregate Bond Index
- Portfolio II: 65% Russell 3000/35% Barclays US Aggregate Bond Index
- Portfolio III: 40% Russell 3000/10% FTSE All World Ex US Index/50% Barclays
Aggregate Bond Index
They also compared performance to a six-factor model – Carhart’s four factors (market beta, size, value and momentum) plus the excess returns of the FTSE Total World Ex US Index and Barclays Aggregate Bond Index. Following is a summary of their findings:
- The average allocation was 50% equities, 33.8% bonds, 9.9% cash (which creates a drag on returns) and 6.4% other assets. Of the equities, 26.4% were non-U.S. and, of the bonds, 15.5% were non-U.S.
- World allocation mutual funds were highly correlated with benchmark indices.
- World allocation funds had lower absolute- and risk-adjusted performance (Sharpe, Sortino and Omega ratios) compared to benchmark indices.
- World allocation funds had a significantly (at the 1% confidence level) negative monthly alpha of 0.1 relative to the six-factor model.
Their findings led Kanuri and Malhotra to conclude that investors in world allocation funds would have been better off with passively managed index funds.
Further evidence
Srinidhi Kanuri found very similar evidence in his study “An Empirical Examination of Lifestyle Mutual Funds,” published in the Winter 2022 issue of The Journal of Retirement, in which he examined the performance of a comprehensive list of all lifestyle funds (surviving as well as dead) from the Morningstar Direct database from January 1994 through August 2017. He found that all lifestyle fund categories (aggressive, moderate and conservative) underperformed all benchmark indexes, had lower risk-adjusted performance (Sharpe, Sortino and Omega ratios) and had negative monthly seven-factor alphas.
Investor takeaways
The evidence presented demonstrates that the efficiency of the market in setting prices combined with the higher expense ratios of actively managed funds, along with the drag on returns created by cash holdings, results in actively managed world allocation funds being another investment product designed to be sold but not bought. Kanuri and Malhotra’s findings add to the overwhelming body of evidence (for example, the annual SPIVA scorecards) that active management (in this case world allocation funds) is highly likely to be a loser’s game, one that is possible to win, but the odds of doing so are so poor it is not prudent to try. The surest way to win the loser’s game is to not play. Instead, build a globally diversified portfolio using only low-cost systematic strategies (such as index funds).
Finally, while the evidence is compelling, unfortunately there are still other negative features of world allocation funds that hold both stocks and bonds:
- For investors with the ability to choose their asset location (taxable versus tax-advantaged accounts), combining equities and fixed income assets in one fund could result in the investor holding one of the two assets in a tax-inefficient manner. If the lifestyle fund is held in a taxable account, the investor is holding the fixed income assets in a tax-inefficient location. If the fund is held in a tax-deferred account, the equities are being held in a tax-inefficient location (losing the benefits of long-term capital gains treatment, the ability to loss harvest, the ability to use the asset as a means of making a charitable contribution and avoiding the capital gains tax, and the potential for a step-up in basis upon death).
- If the fund is held in a taxable account, the investor loses the ability to loss harvest at the individual fund level.
- If the fund is in a tax-deferred account, the investor loses the ability to use any foreign tax credits that are generated by the international equity holdings. Even in a taxable account, as a fund of funds the investor loses the ability to utilize the foreign tax credit.
- If the fund is held in a taxable account, the equities should be in funds that are tax managed, or in ETF instead of mutual fund form. I am not aware of any lifestyle or balanced fund that tax manages the equity portion (which makes sense because the fund does not know which location it will be held in).
- For investors who manage their own IRA accounts, the fixed income allocation will not include CDs or multi-year guaranteed annuities (MYGAs), both of which can provide higher yields than Treasury securities without incurring credit risk (if one stays within insurance limits) while also avoiding the lifestyle fund’s expense ratio. In addition, Treasury bonds, a typical lifestyle fund holding, can be purchased by individuals without any expense ratio.
Individually, each of the above are important negative features that impact the after-tax return of the fund. Collectively, they can be very damaging. Unless an investor is holding all of their investable assets in a tax-deferred account, global allocation funds are not a good choice. The more efficient investment strategy is to hold the individual assets in separate funds and in the most tax-efficient location. The key is to then have the discipline to rebalance and adhere to your well-thought-out plan.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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Read more articles by Larry Swedroe
Actively managed global allocation funds are designed to add value by shifting between asset classes and geographical regions based on the fund manager’s outlook for market conditions – they tactically allocate. Their marketing pitch is that skilled investment managers can produce a superior rate of return compared to traditional index funds. But the reality does not match the hype.
Their findings led Kanuri and Malhotra to conclude that investors in world allocation funds would have been better off with passively managed index funds.
