In economics, it is said that there is no such thing as a free lunch, except perhaps diversification. Typically, one can not achieve higher returns without taking on additional risk. However, if assets are uncorrelated--some rising while others falling--diversification can result in better returns without taking additional risk. For the low cost of about 0.30%, this fund provides a diversified, automatically rebalanced portfolio of stocks and bonds.
iShares S&P Aggressive Allocation (AOA) is a one-stop asset-allocation fund that holds both equities and bonds, with a heavier weighting in equities given its aggressive orientation. It is intended to serve as an investor's core holding, either by itself or paired with a few alpha-seeking active funds. For investors who do not have the time or inclination to research, monitor, and rebalance multiple funds, allocation funds such as this provide a simple and effective solution. The fund invests in eight individual iShares ETFs covering domestic and international stocks and bonds with a larger allocation toward stocks than bonds to reflect its aggressive designation. One criticism of this approach is that because investors often do not research the underlying investments in an allocation fund, the portfolio can sometimes be stuffed with lower-quality funds. That is not the case here, as each of the component iShares products is high-quality and follows a passive, index-based approach.
A key benefit to an asset allocation fund such as AOA is that it automatically rebalances the portfolio for you. Rebalancing is a key step in keeping a portfolio's risk within predetermined parameters. Without rebalancing, a portfolio can quickly become heavy in a trending asset class. For example, with rebalancing, a 50/50 stock bond portfolio has historically had a volatility of return of about 11%. Without rebalancing, that volatility increases to 16%. Because of behavioral biases, investors often fail to rebalance in a disciplined manner. During the financial crisis, when stocks sold off and rallied sharply, the prudent course of action would have been to sell bonds and increase the allocation in equities, but at the time, this would have been a unnerving proposition.
For passive investors or those seeking to simplify their portfolio decisions, asset-allocation funds such as this offer some advantages to picking individual stocks or funds. For example, once you decide on your risk-tolerance level, the fund handles all of the asset-allocation and rebalancing decisions for you. A rebalancing plan helps investors buy low and sell high as past winners are trimmed and the proceeds are reinvested in past losers.
The financial crisis has forced investors to reassess asset allocation and their own tolerance for risk. Many people close to or in retirement realized that their exposure to stocks was too large and resulted in too much volatility in savings. The S&P 500 has gained just 4.1% per year annualized over the last decade, while the Barclays Aggregate Bond Index has gained 5.7% over the same period. That does not mean that investors should rush into bonds, particularly given the fact that equities are now more reasonably valued than they were three years ago, and dividend yields are in some cases higher than the historically low bond yields. While many market prognosticators have said that we are in a "bond bubble" it is also true that bond interest rates may remain low for an extended period of time, much as they have in Japan. While this fund should outperform bonds when stocks do well, keep in mind that U.S. and international stock markets may move in different directions. Investors not interested in trying to time the market can take comfort in this fund's lower volatility and balanced allocation approach.
Over the past three years, this fund has had a standard deviation of 16%, about the same as the S&P 500's. One way to interpret this number is that over a given year, you can expect the fund to return within plus or minus 32% of its long term average with 95% confidence. While the 19% allocation to bonds helps reduce risk, emerging-markets and small-cap stocks increase it.
The beauty of a broad index approach followed by the component ETFs in this fund is that investors do not have to have an explicit view on the markets but are relying on the efficient-market hypothesis, which suggests that, in aggregate, investors cannot consistently beat the market on a risk-adjusted basis. This is why active fund managers have a difficult time beating the market. Proponents of the efficient market view, such as Eugene Fama and Burton Malkiel, believe that indexing is the superior approach to investing.
The fund follows the S&P Target Risk Growth Index and is composed of eight iShares ETFs: iShares Barclays Aggregate Bond (AGG), iShares Barclays TIPS Bond (TIP), iShares iBoxx H/Y Corporate HYG, iShares S&P 500 (IVV), iShares MSCI EAFE (EFA), iShares S&P MidCap 400 (IJH), iShares MSCI Emerging Markets (EEM), and iShares S&P SmallCap 600 (IJR). These component funds follow broad, passive indexes and the weighting in each is rebalanced annually. Unlike target-date funds, which reduce risk as the target date approaches, these funds are designed to maintain a steady risk tolerance. Unlike the three other funds in this series, AOA does not include iShares Barclays Short Treasury Bond (SHV).
This fund charges a 0.33% expense ratio, which is about 0.11% higher than the weighted average expense ratio of the underlying funds. The additional 0.11% on top of the expense ratios of the underlying funds is paid for the convenience of not having to rebalance and for having only one fund instead of nine. We consider AOA's expense ratio to be low, particularly when compared with similar funds.
This fund is one of four iShares allocation ETFs, which range from conservative to aggressive. These funds include iShares S&P Conservative Allocation (AOM), iShares S&P Moderate Allocation (AOK), and iShares S&P Growth Allocation (AOR). Each of these funds charges 0.11% on top of the fees charged by the underlying funds, and they invest in the same iShares funds as AOA but at different weightings to reflect their varying risk tolerance. Although the trading volumes in these allocation ETFs are relatively low, the underlying ETFs that these funds invest in are liquid. Investors should get good execution, but when trading large dollar amounts, be sure to use limit orders and be patient.
There are many more asset-allocation fund options in the mutual fund vehicle. Investors should examine our Fund Analyst Favorites in the aggressive allocation category. One such fund with a four star rating is the T. Rowe Price Personal Strategy Growth (TRSGX), though it has a higher expense ratio (0.77%).
Investors always have the option to invest directly in the underlying funds. IShares also offers a series of target-date funds such as iShares S&P Target Date 2040 (TZV), which is constructed in a manner similar to this fund except that it will reduce its risk allocation as the target dates approaches. These products have not yet attracted significant assets. DBX Strategic Advisors, a unit of Deutsche Bank, also offers target-date products such as TDX Independence 2040 (TDV). TDV charges an expense ratio of 0.65%, and although it invests directly in individual securities instead of other funds, this fee is still greater than the combined fee of the iShares offerings.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.