BUSINESSWEEK ONLINE : JULY 17, 2000 ISSUE
COVER STORY

Diversification Made Easy
Funds of funds, or lifestyle funds, take care of all the homework

Not every investor has the time or inclination to build a well-balanced portfolio. For those who find pie charts unappetizing, funds of funds are a palatable alternative. Also known as lifestyle funds, these funds buy other funds, building a diversified portfolio designed to reach a specific investment goal. For instance, Fidelity Freedom 2010 is a fund of funds designed for investors expecting to retire in 2010. It does all the allocating for you, investing in 17 different Fidelity stock, bond, and cash funds.

But this solution comes with a price. Most funds of funds charge fees--on top of those already charged by the underlying funds. According to Morningstar, the average fund of funds adds 0.63% in expenses. The average expense ratio of U.S. stock funds is 1.4%, so a stock fund of funds could boost your total expenses to more than 2%--which over time can dramatically reduce returns.

Not every fund of funds includes these double charges. Vanguard, TIAA-CREF, and T. Rowe Price all offer products without secondary fees. Vanguard has four different LifeStrategy funds of funds that invest primarily in index funds, so the total expenses are even lower than usual: around 0.29%. ''For someone with only $5,000 or $10,000 to invest, I recommend Vanguard's funds of funds all the time,'' says financial planner Brent Brodeski of Savant Capital Management in Rockford, Ill.

Understanding a fund of funds' allocation policy is crucial. TIAA-CREF Managed Allocation, for instance, works around a 60-40 split between stocks and bonds that rarely changes. It has turned over a mere 4% of its portfolio in the past year. But such funds as Merriman Asset Allocation like to trade in and out of funds to time the market. Merriman's turnover ratio is an enormous 351%. Such heavy trading incurs high tax bills, and leaves investors in the dark as to their allocations.

FUGGEDABOUDIT. Fidelity's Freedom funds take a unique approach. As the funds near their target dates--2000, 2010, 2020, and 2030--their managers gradually shift the allocations away from stocks toward bonds and cash. This strategy increases income and reduces risk for retirees, a convenience if you just want to buy one fund and forget about it. Fidelity does charge a secondary fee, but it's a low 0.08%.

If funds that buy other funds make you dizzy, consider balanced funds, which have only one layer of fees, but are often not as diversified. According to Morningstar, the average balanced fund has a foreign stock weighting of only 3.8% and a median market capitalization of $46 billion. That means the funds own mostly large U.S. stocks.

But there are worthy exceptions. The socially responsible Pax World Fund has a 10.7% exposure to foreign stocks. It also has a track record of high returns, low risk, and moderate expenses. Manager Christopher Brown thinks balanced funds have an advantage: ''You get a portfolio manager looking at the overall picture rather than one manager for bonds and one for equities.'' And balanced fund managers can add value directly with their own stock and bond picks--something no fund of funds manager can do.

By LEWIS BRAHAM

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