Balanced & Lifestyle Funds


One thing the mutual fund industry does well is to create a product and then create demand for that product, even when the product may not be one that is in the investors' best interests. Variable life insurance, most variable annuities, sector funds, and hedge funds generally fit into the category of products that are meant to sold, not bought. One mutual fund product that has proliferated in recent years is the balanced, or lifestyle, fund. The idea for the product is fundamentally sound - create a fund of funds that invests in various asset classes. These funds can be structured to accommodate investors covering the full spectrum from aggressive (one hundred percent equity allocation) to very conservative (twenty percent equity allocation).

These funds provide the following benefits:

  • They allow investors to hold in one fund a diversified portfolio that can include exposure to both U.S. (typically large, large value, small, and small value) and international (typically international large and possibly including emerging markets) equities.
  • The fund automatically rebalances its assets to the targeted exposures, providing discipline.
  • If the fund is not an all-equity fund, it will also rebalance between equities and fixed-income - again, providing discipline.

Unfortunately, there are some important negative features that should not be ignored:

  • Unless the fund is an all-equity fund, combining equities and fixed-income assets in one fund results in the investor holding one of the two assets in a tax inefficient manner. If the fund of funds is held in a taxable account then the investor is holding the fixed-income assets in a tax inefficient location. If the fund is held in a tax-deferred account then the equities are being held in a tax inefficient location (losing the benefits of long-term capital gains treatment, the ability to loss harvest, 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 asset class level.
  • If the fund is in a tax-deferred account then the investor loses the ability to use any foreign tax credits that are generated by the international equity holdings.
  • If the fund is held in a taxable account the equities should be in funds that are tax-managed. I am not aware of any lifestyle or balanced funds that use tax-managed funds for the equity portion (which makes sense since the fund does not know in which location it will be held).
Individually, these are all important negative features that impact the after-tax return of the fund. Collectively, they are very damaging. The bottom line is that unless an investor is holding all of their investable assets in a tax-deferred account, lifestyle funds are best avoided. The more efficient investment strategy is to hold the individual assets in separate funds and in the most tax efficient location. The key then is to then have the discipline to rebalance and adhere to your strategy.