You can get all the diversification and safety you need with just one fund. March 31, 2006 Ray Steward knows something about building. At one time he built decks, and then he built a deck-building business, which now employs 11 people and is based in Towson, Md. While he no longer straps on a tool belt, as a small-business owner he handles marketing, payroll and even benefits, which he says are key to keeping "my big family" together. "Workers in this industry are so transient," he says, "if you want to keep them, you have to offer them some security."Part of that security comes from a retirement plan that offers mutual funds that a busy guy like Steward can appreciate. Each fund is a pre-built portfolio of other funds. So instead of owning several funds to reduce risk by diversifying, Steward and his employees can pick just one. No question, a one-stop fund can simplify your life. Steward, for example, held a number of funds in different accounts before consolidating his investments into a single T. Rowe Price fund. "I have enough bottles to wash as it is," he says. But are do-everything funds solid investments? Some are, definitely. As with any type of mutual fund, there are top performers, also-rans and downright dogs. In this story we'll explain the different types of one-stop funds that are available and name the top ones. Advertisement Why diversify? But first, you may wonder how a single fund can handle all your investment needs, and how we judge such funds. A good one-stop fund must be well diversified. It must have low expenses. And it must have a good performance record. When combined, these three factors will give you high and relatively steady returns. One-stop funds diversify by owning a broad range of investments because the specific stock or bond you invest in isn't as important as having different types of investments. And diversification is key for steady returns. For example, if you invested in a broad selection of nothing but small U.S. stocks, you would have seen a 47% return in 2003 but a 20% loss in 2002. But investing half your money in bonds during those years would have cut the 2002 loss to 5% and reduced the 2003 gain to 26%. If you diversify further by combining that portfolio with stakes in other types of investments -- such as foreign stocks and stocks of big U.S. companies -- you will have even steadier returns. Advertisement By placing your money in a broad range of investments, you pass up the chance to beat the ballpark 10% average annual return such investing gives you. But you also pass up an even better chance that you won't earn that much. Donald Chambers, a finance professor at Lafayette College, says people often resist such simple solutions as one-stop funds, even though they work. "Simple answers," he says, "remove the idea that we can digest complex information and win." But the truth, Chambers adds, is that not only do most investors not do as well as the market average, but most professional investors don't do as well either. While diversification is guaranteed to even out your year-to-year return, low expenses are guaranteed to improve it. High expenses -- what you pay the fund company in order to buy and own a fund -- erode your return over time. Since one-stop funds are most often used to save for retirement, investors need to insist on low expenses. Say you are investing your $100,000 nest egg in a fund that returns 10% every year before expenses. If this fund charges 2% in expenses annually, you'll have $466,000 after 20 years. But if the fund charges just 1%, you'll have $560,000. Target-retirement funds Of all the types of one-stop funds, so-called "target-retirement funds" are the most popular. These funds become more conservative -- with fewer stocks and more bonds -- as you grow older, so they match your need for more financial stability as you approach retirement. The simplicity of target-retirement funds makes them a popular choice for 401(k) plans. Advertisement Ray Steward, 43, and his wife, Sandra, 40, own a target-retirement fund called T. Rowe Price Retirement 2030 -- 2030 being the approximate year they plan to retire. The fund holds about 90% stocks and 10% bonds and cash. The portion that's in stocks is divided among eight actively managed T. Rowe Price stock funds. Together they cover the stock market from every useful angle: small, midsize and large companies; value and growth stocks; and international companies. Right now, this fund is mainly invested in stocks. Although stocks are more volatile than bonds, they return more over the long term -- and two dozen years is indeed the long term. The T. Rowe Price Retirement fund with the longest time horizon -- Retirement 2045 (the funds are offered in five-year increments from 2010 to 2045) -- also has 90% in stocks. By contrast, the shortest-term fund (2010) currently has 35% in bonds and cash. T. Rowe Price Retirement Income fund (for your investments during retirement) holds about 40% stocks, with the remaining 60% split evenly between bonds and cash. Target-retirement funds are a great idea, but only T. Rowe Price and Vanguard offer such funds that meet our diversification, expense and performance criteria. Advertisement T. Rowe Price Retirement funds tend to be weighted more heavily toward stocks, and they more closely follow the proportion of stocks we think is appropriate for different life stages. For example, the most conservative fund, Retirement Income, holds 40% stocks, while similar funds from other fund families generally contain only about 20% stocks. Given how long retirees now live, they need the growth that stocks provide. And this higher growth should occur with only a little more volatility. Of course, for a higher proportion of stocks in your portfolio, you could simply lie about your age. If you have, say, 15 years until retirement, instead of buying a 2020 fund, you could buy a 2030 fund -- or whatever fund suits the mix of stocks and bonds you feel comfortable with. Like other target-retirement funds, T. Rowe Price Retirement funds don't have long-term records because this type of fund has only been around for a few years. But the majority of the underlying funds that make up target-retirement funds do have long records. By looking at these component funds, we've come up with a rough estimate of target-retirement funds' long-term performance. And that performance is solid. For example, compare the Retirement funds with the longest time horizons -- which hold 90% stocks and 10% bonds and cash -- with a portfolio that invests 90% in Standard and Poor’s 500-stock index and 10% in a general bond index. The annualized return of these T. Rowe Price funds in the past ten years would have been 10%, versus 9% for the index portfolio. A comparison between T. Rowe Price's shorter-term, more conservative funds and an index portfolio -- both 60% stocks and 40% bonds -- tells a similar story. The Retirement funds would have had a 9% annualized return, versus 8% for the indexes. Vanguard Target Retirement funds differ from T. Rowe Price's target-retirement funds in three main ways. Vanguard's funds are more conservative (with less in stocks), they use index funds almost exclusively, and they have lower expenses. For Robert States, 44, chief operating officer of an international consulting firm in suburban Buffalo, N.Y., the index fund philosophy makes complete sense. He doesn't want to be one of the many investors who get burned regularly by chasing fund performance. Trying to invest in a top fund year in and year out "is like trying to live in one of the best places to live every year -- you would have to move every year," he says. Index funds simply mirror different segments of the market, and most index funds have excellent track records compared with actively managed funds. For example, the SP 500 index beat 85% of actively managed big-company stock funds over 20 years. Vanguard's target-retirement funds definitely have the edge when it comes to expenses. Its funds charge about 0.21% -- a fraction of the 1.2% fee levied by the average target-retirement fund. Here again, States likes the Vanguard approach. "I'm not a big fan of turning over a big piece of whatever return there is to the fund managers," he says. That's particularly important in very long-term investments, such as target-retirement funds, he adds. The T. Rowe Price target-retirement funds are inexpensive compared with the average cost of all mutual funds, but because they are actively managed -- and require staffs of managers and analysts -- they have to charge more than index funds. Price charges 0.67% for the Retirement funds with the lowest percentage of stocks, up to 0.81% for the funds that hold the most stocks. The most aggressive of Vanguard’s target-retirement funds is Target Retirement 2045. (There are five funds in this series: four at ten-year intervals starting with Target Retirement 2015, plus a Target Retirement Income fund.) About 70% of Target Retirement 2045 is made up of Vanguard Total Stock Market Index fund, which follows a broad measure of all U.S. stocks -- from small to large -- called the MSCI U.S. Broad Market index. The rest of the fund is split between indexes of foreign stocks (18%) and bonds (12%). Although the Target Retirement funds started in 2003, their component parts have been around much longer, giving a glimpse of how well they would stack up over a longer period. Target Retirement 2045 would have had a ballpark 8.5% annualized return over the past ten years. The most conservative fund, Vanguard Target Retirement Income, invests 50% in a general bond index, 25% in a non-index fund that invests in inflation-protected securities, 20% in Total Stock Market Index and 5% in a money-market fund. It would have returned an annualized 7% in the past ten years. If the T. Rowe Price retirement funds have better returns by a percentage point or two, why should you consider the Vanguard retirement funds at all? Although Vanguard's extremely low expenses haven't helped the company's funds beat T. Rowe Price's funds in the past ten years, by our estimates, low expenses are a powerful force, especially with investments that stretch over decades. So while we give T. Rowe Price funds the nod, Vanguard's are worthy competitors. Lifestyle funds The spiritual parents of target-retirement funds are well-diversified funds whose proportions don't change over time. These are labeled asset-allocation, lifestyle or life-strategy funds, and they're also growing in popularity among investors. They make sense if you're comfortable with one mix of investments, either because of temperament or because you have an investment picture that makes the changing asset mix in a target-retirement fund impractical. Mutual fund companies set these funds up in a variety of ways. But the idea is complete diversification in three basic levels of risk and reward. The ones with the highest risk and reward often have "growth" as part of their name. These are mainly stock funds, and they're the rough equivalent of the lifestyle funds for people retiring in 30 or so years. Those called "balanced" or "growth and income" funds are about half stocks and half bonds, and those called "income" are mostly bonds. You can see the trade-off between these three basic flavors of funds in the T. Rowe Price Personal Strategy funds. Personal Strategy Growth fund, with 85% stocks, is 28% less volatile than the SP 500 and has returned an annualized 11.5% since it began in 1995. That matches the SP 500's record. (The past decade included a ruinous bear market in stocks but no such down cycle for bonds, and there's no guarantee that having bonds in your portfolio will nudge up the total return during the next decade.) Personal Strategy Balanced fund, with 65% common stocks, is 44% less volatile than the SP and has returned 10.5% since its start in 1995. Personal Strategy Income is 59% less volatile than the SP and has returned 9.4%. Giving up a percentage point or two in return for that much less volatility is a good deal, and it puts the T. Rowe Price funds at the head of the lifestyle fund class, blowing away most of the competition. Lower volatility translates into much more consistent returns. For example, in the past ten years the SP 500 had some wild swings, dropping in three years (2000–02) and gaining 38% in 1995. By contrast, Personal Strategy Income dropped in only one year (3% in 2002) but gained only 25% in 1995. Instead of being a collection of other T. Rowe Price funds, Personal Strategy funds are put together under the direction of Ned Notzon, the company’s asset-mix guru. Notzon relies on T. Rowe Price fund managers to make the stock selections. Vanguard also has some solid lifestyle funds. Vanguard LifeStrategy funds come in four variations, all of which are combinations of index funds. Each LifeStrategy fund also has 25% in Vanguard Asset Allocation fund, which can vary from all stocks to all bonds, depending on what its managers feel is the best investment profile at the time. Vanguard charges a 0.28% annual fee for the LifeStrategy funds, versus 0.75% charged by T. Rowe Price for Personal Strategy Income, 0.86% for Personal Strategy Balanced and 1% for Personal Strategy Growth. Of the four LifeStrategy funds, Growth has the highest percentage in stocks (90%). Its ten-year record is an annualized 8.7%, and it’s 19% less volatile than the SP 500. LifeStrategy Moderate Growth (70% stocks) returned an annualized 8.4% in ten years, with 38% less volatility than the SP 500. Conservative Growth (50% stocks) returned 7.8% with 57% less volatility, and Income (30% stocks) returned 7.3% with 72% less volatility. So again, T. Rowe Price beats the Vanguard funds, despite Vanguard's frugal expenses. But those low expenses may work to Vanguard's advantage over time.