Target Allocation ETF Investing 101 (AOA, AOK, AOR, AOM)

Eric Dutram: In these volatile times, most investors are faced with the dilemma of deciding which asset class to put their hard earned capital to work in. During times of economic uncertainties, most investors turn to less risky securities in order to help defend against volatility.

However, these safe haven assets, more often than not, are not as safe as they seem and often times the yield on these securities are not up to par. For example, bonds are considered to be safer than equities by most investors in a medium time frame (assuming flat interest rates).

Yet, at current levels when the 10 year benchmark rates are nearing an all time low, bond investors are almost certain to lose money when rates again begin to rise (read Should Retail Investors Invest In Treasury Bonds?).

Recent developments in domestic as well as global markets have led to increased volatility across all asset classes. The broader markets have recovered strongly since the start of fiscal 2012, mainly thanks to two quarters of better-than-expected earnings season, and a somewhat impressive GDP growth rate.

However, exchange traded funds (ETFs) have gained immense popularity in the recent past, given their holistic investment approach and tax efficiency, coupled with flexibility and ease of investing (see Two ETFs that Have Surged from Their Lows). ETFs can be viewed as the ultimate asset allocation instrument providing investors a readymade portfolio of stocks or fixed income securities or both.

Allocation ETFs

Among the many options available to the investors in the form of ETFs, we would like to highlight four unique funds by the iShares fund family which could go a long way in aligning investors’ risk-return tradeoff based on their risk appetite, especially in times of economic uncertainty.

These ETFs are allocation ETFs which provide investors with a blended portfolio of fixed income securities and equities to suit their preferences. iShares S&P Aggressive Allocation ETF (NYSEARCA:AOA), iShares S&P Conservative Allocation ETF (NYSEARCA:AOK), iShares S&P Growth Allocation ETF (NYSEARCA:AOR) and iShares S&P Moderate Allocation ETF (NYSEARCA:AOM) provide investors the balanced approach required to tap the potential of each market segment.

From an allocation point of view, each of these ETFs tries to justify its investment objective by striking a balance between equity and debt exposure. However, these ETFs are not complimentary to each other and the performance of each is heavily dependent on the level of assets that are dedicated to each asset class (readBuild a Complete Portfolio with These Three ETFs).

For example, the performance of AOA which has an 81% allocation towards the equity markets would be more dependent on the equity market performance, rather then the fixed income market segment to which it has a 19% allocation.

The table below (i.e. table 1) summarizes the attributes of the ETFs from a risk return trade off point of view. In order to highlight this we have simulated the past performances of the individual ETFs and ascertained a return per unit of risk score (to simulate the risk adjusted returns) and then ranked them on the basis on this score.

To get a better picture, we have used the three year price performance data of the individual ETFs to ascertain the standard deviation (risk) and the total returns. The score was ascertained by dividing the returns by the risk and higher score signifies a better risk adjusted performance.

Table: 1 (data as of 31st August 2012)

ETF Allocation Fixed income to Equity ratio 3 Year Annualized Standard Deviation (Risk) 3 Year Returns Returns per unit of Risk score Rank
AOA Aggressive 19:81 18.09% 36.71% 2.03 4
AOK Conservative 74:26 4.94% 19.96% 4.04 1
AOR Growth 40:60 12.10% 27.93% 2.31 3
AOM Moderate 60:40 7.91% 22.50% 2.84 2

Not surprisingly, it is noticed that standard deviation (risk) tends to increase with the ETFs having more allocations towards equity. Also, from an absolute returns point of view the returns tend to increase as allocation towards equity increases. However, taking a look at the table from another point of view, it is another story.

From a risk adjusted returns point of view, the ETFs with greater allocation towards fixed income securities have outperformed as of late when compared to their equity concentrated cousins. For example, AOK which has a conservative allocation of 74% debt and 26% equity has a returns per unit of risk score of 4.04 and arank of 1, compared to its aggressive counterpart AOA, which has an aggressive allocation of 19% fixed income and 81% equity, yet a score of 2.03 and is ranked 4th (see more in the Zacks ETF Center)

However, it should be noted that the suitability of each ETF depends on individual investor risk appetite and the current scenario of the capital markets. For example, in a bull marketAOA is most likely to outperform its peers and is suitable for investors with an above par risk appetite.

On the contrary, AOK is most likely to post an impressive performance in a bear market and would be an appropriate choice for conservative/risk averse investors (see Is It Time for an Equal Weight ETF?).

It is also prudent to note that all these ETFs do not invest in securities directly. However, they invest in a portfolio of other ETFs belonging to the same fund family i.e. iShares. Therefore, these allocation ETFs qualify to be called ETFs of ETFs, however, unlike other ETF of ETF counterparts they do not charge a hefty expense ratio, thanks to the fund manager focus being limited to their own fund family (see Five Cheaper ETFs You Probably Overlooked).

All these iShares allocation ETFs were launched around the same time in 2008 and charge pretty much the same expense ratios ranging from 0.30% to 0.33%. Among the four ETFs the moderate and growth allocation ETFs i.e. AOM and AOR have attracted the most inflows in their asset base with $153.31 million and $ 136.41 million respectively in total assets.

AOA and AOK have $97.30 million and $89.30 million in their asset bases. Also, among the four allocation ETFs, AOK seems to be the most popular from a volume perspective, trading 46,000 shares per day on an average. The average daily volumes for other ETFs are 13,000 shares for AOA, 21,000 shares for AOR and around 27,000 shares for AOM. All these ETFs have yields around the 2% level.

The following table (i.e. Table 2) summarizes the general attributes of the iShares allocation ETFs, any of which could be interesting picks for investors seeking broad exposure in a certain risk bucket:

Table 2:

ETF Average Daily Volume Expense Ratio Total Assets Yield
AOA 13,000 0.33% $97.30 million 2.12%
AOK 46,000 0.30% $89.30 million 1.95%
AOR 21,000 0.31% $136.41 million 2.11%
AOM 27,000 0.31% $153.31 million 2.06%

Written By Eric Dutram From Zacks Investment Research  

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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