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Actively managed asset allocation products are hot. The supply is growing rapidly and there's a broad variety of strategies to choose from. The product designs range from conservative balanced funds to aggressive trading-oriented strategies and they're available in open-end mutual funds and ETF formats. But some things never change, and so it's still hard to beat a passive benchmark of all the major asset classes. That headwind alone doesn't necessarily mean that you should shun actively managed multi-asset class funds, but it's a reminder that there's no free lunch in this corner of investment products. In other words, all the standard caveats that apply to active single-asset class funds apply here. Your mission, if you choose to accept it, is figuring out if you can overcome the odds.

One of the main hurdles with multi-asset class funds is sorting through the list and figuring out who's offering what and which strategies soar or crash. A recent Morningstar report notes that assets in ETFs that own a mix of other ETFs have grown 43% for the year through January 2012. By Morningstar's reckoning, there are 370 ETF products with $27 billion in assets in this field. The list is much longer if you include open-end mutual funds, which includes the popular target-date funds.

There's also a lot of interest in the sub-category of tactical asset allocation funds, but definitions can get hazy. ”There's much debate over what's tactical and what's not," Michael Herbst of Morningstar writes. "Unfortunately there's not yet an easy, quantitative way to identify tactical funds or classify their strategies." Herbst goes on to advise:

In many cases, you won't be able to tell what a tactical fund is actually doing to pursue its goal. Tactical funds are apt to adjust their holdings quickly and in many cases dramatically, so it's tough to know exactly what the fund owns or is exposed to at any given time. Many adjust their market exposure by taking long and short positions with derivatives such as futures, forwards, and options, as well as interest rate, credit default, and total return swaps. Derivatives themselves aren't necessarily problematic because managers can use them to adjust portfolios more nimbly and cheaply than they could by buying and selling stocks and bonds. But derivatives markets can seize up, and managing long and short positions can be difficult in volatile markets, which is when tactical funds are supposed to shine….

Given the complexity of many tactical strategies, it can be difficult if not impossible to tell how a tactical fund is invested by looking at its portfolio holdings or the conventional asset-allocation data that many managers provide.

The bottom line, Herbst concludes: "Many tactical fund managers employ complex strategies and sport short track records, making it tough to assess how effectively they're plying their strategies."

What is clear is that the vast majority of tactical funds, when lumped in with the various other flavors of actively managed asset allocation products, deliver mediocre results in the aggregate. The reason is that beating the market—broadly defined across multiple asset classes—is difficult. Last month I updated how 1,000-plus multi-asset class mutual funds and ETFs with at least 10 years of history fared against the Global Market Index (GMI), a passive value-weighted mix of the major asset classes. The result is predictable: GMI earned above-average performance over the past 10 years relative to its competitors overall.

What explains GMI's strong performance? All the advantages that makes single-asset class indexing so compelling apply here as well, starting with low fees. For instance, you can replicate GMI with ETFs for under 50 basis points. By comparison, many actively managed asset allocation products come with much-higher expense ratios, in many cases well north of 100 basis points.

Choosing an actively managed asset allocation fund can be worthwhile if you find a product with a talented manager. But that's not going to be easy. Portfolios that swim in several asset classes employ a broad array of techniques for managing the mix. Apples-to-apples evaluation requires a fair amount of analysis. And there's ongoing monitoring to consider too. Given the complexity of some of these products, and the lag time in portfolio updates, that could be another headache. Still, if you do your homework, you may be able to identify promising funds that match your risk tolerance and investment objectives. But you'll need a high degree of confidence that a given manager is worth a relatively high expense ratio.

If you do wade into these waters, make sure you're clear on what you're looking for. High returns? Risk management? Some of both? The sky's the limit for strategic possibilities. The historical track records, however, are more likely to be grounded in terra firma. Some funds manage to break free of the crowd and deliver impressive results. But figuring out who'll be in that rarefied club next year—and for years after—is one of the tougher challenges in investment research, and the burden falls on you (or your advisor).

Source: Kicking The Tires Of Multi-Asset Class Funds