Rebalance Your 401(k) With This Annual Checkup

With the average American's 401(k) balance remaining unchanged or even decreasing over the past year, it's definitely time to start examining your plan and fund choices more closely.

While at our firm we primarily manage our clients' assets in stocks and bonds, we do make recommendations on what they should do with their 401(k) accounts, and here are the steps we go through.

First, I generally recommend limited fixed-income exposure and no money markets for these assets -- you can afford to take the biggest risks with equities here until you're 10 years or less from retirement.

When I look at the equity-fund options, I usually start with the funds with the best five-year returns, and then look for a combination of styles that gives the best overall returns with the least risk, which I define as the chance of having a negative year. Funds are broadly defined as growth and value, with subdivision into small-, medium- and large-cap funds. Generally, growth zigs while value zags, so growth and value funds may have the same overall five-year returns, but widely divergent one-year returns for each of the past five years. In combination, the one-year returns smooth out.

Here are the options available to one client whose 401(k) I reviewed recently:

Annualized Returns Through 6/30/01
Fund	Started	1 Year	3 Years	5 Years
Short-Term Investments
Vanguard Admiral Treasury Money Market	1992	5.71%	5.27%	5.28%
Vanguard Prime Money Market	1975	5.91	5.53	5.48
Bonds
(VFSTX)Vanguard Short-Term Corporate	1982	10.05	6.43	6.68
(VBMFX)Vanguard Total Bond Market	1986	11.52	6.31	7.49
(BTFIX)American Century 2005	1985	11.45	5.79	8.04
(BTTNX)American Century 2010	1985	13.20	5.38	9.46
(BTFTX)American Century 2015	1986	10.27	3.56	10.06
Lehman Aggregate Bond Index		11.23	6.26	7.48
Balanced (Stocks & Bonds)
(VWELX)Vanguard Wellington	1929	15.41	6.99	12.75
Domestic Equity
(VFINX)Vanguard 500 Index	1976	-14.85	3.91	14.45
(VTSMX)Vanguard Total Stock Market Index	1992	-15.07	3.71	13.14
(VEXMX)Vanguard Extended Market Index	1987	-18.79	3.23	10.13
(BRWIX)Brandywine Fund	1985	-14.55	12.05	13.11
(SSHFX)Sound Shore Fund	1985	22.53	6.38	15.05
(SAFGX)SAFECO Growth	1968	23.34	3.44	16.73
(MACGX)MAS Midcap Growth	1997	-28.00	11.88	20.25
S&P 500		-14.83	3.89	14.48
International Equity
(JAOSX)Janus Overseas	1994	-32.37	6.56	13.64
Source: Fund company statements

Usually, a 401(k) statement will list the fund options, multiple period returns and a small amount of descriptive text. To research your options, start with TheStreet.com's FundQuote tool and look up the symbols of all your options. A summary of each fund is found under the Quotes tab, but the more interesting detail is found under the Thompson Reports tab. Look, for example, at the Thompson report on Vanguard Index 500.

On this report, if you didn't have return information, you could see performance over multiple time frames. Generally, I look at one-, three- and five-year returns because that gives me a fair amount of information about how the fund has performed through a variety of market conditions. Returns of less than one year are usually too volatile to be meaningful, and I usually ignore any fund with less than a five-year track record. You can also consider 10-year returns.

I also like to review the top equity holdings. Funds with more than 5% of their assets in any one company are riskier than more diversified funds, so I would generally discard such funds from further consideration. I don't like to see too much replication of positions. If, for example, three funds all have General Electric, Microsoft and Cisco as their top holdings, I would pick only one fund from this group

The Modern Portfolio Theory section in the Thompson Reports area offers two useful statistics -- beta, which is the degree to which the fund is correlated with the S&P 500; and alpha, the percentage the fund has over or underperformed relative to the S&P 500 given the riskiness of the fund. The Brandywine Fund, for example, has a three-year beta of 1.01, which means that it moves up or down pretty closely in sync with the S&P 500. But it has a three-year alpha of 11.18, which means that the portfolio manager delivered an 11% excess return over the S&P 500, given its level of risk (note: Brandywine's three-year alpha is unusually high, reflecting its strong recent performance).

Not surprisingly, Brandywine is in the top 8% of funds in its category for the past three years. Typically, I like to see the funds remaining among the top 33% of funds in their category over all time frames because that shows consistency. It's not realistic to look for funds that are in the top 10% of their category over all time frames. A fund in the top 10% for the most recent year but below 35% for longer time frames is likely the beneficiary of a quirk in the investment environment and should be avoided.

Additional information can be obtained from Morningstar. I'm interested only in funds that have four or five stars -- this indicates that returns are in line with risks according to Morningstar's evaluation. I also note from a fund's Quick Stats the Category rating -- either small-, mid- or large-cap focus, and growth, value or blend strategy. To improve diversification, I'd rather have one large-cap growth fund, one large-cap value fund and one small-cap growth fund, rather than three funds all categorized as large-cap growth.

By process of elimination, I end up with four funds from the list above that I feel comfortable recommending: (VWELX)Vanguard Wellington, an equity fund with a small fixed-income exposure; (BRWIX)Brandywine, a growth fund; (SSHFX)Sound Shore, a value fund; the (VFINX)Vanguard 500 fund, a value/growth blend. I don't like overseas funds like the (JAOSX)Janus Overseas, which are, on average, more volatile on the downside. Non-U.S. markets are increasingly correlated with the S&P 500, and 40% of S&P 500 earnings come from overseas anyway, so having overseas funds doesn't reduce risk.

The recommended funds averaged 13% to 15% annual returns over the past five years, while the S&P 500 returned 15.6%. Because the fund's individual average returns are lower than the S&P 500, you'd think it might make more sense to have just put all your money in the Vanguard Index 500 fund.

In fact, though, a simple 25% allocation to each of these funds, rebalancing annually, would have returned an average of 18.6% annually over the past 10 years, vs. approximately 14.5% for the S&P 500. The reason is that by rebalancing, you're taking money out of the top-performing funds and moving it into lower-performing funds, essentially buying low and selling high.

In 2000, for example, a combination of 25% Wellington, 25% Brandywine, 25% Sound Shore, and 25% Vanguard Index 500 fund would have gained 7.1% vs. a loss of 9.1% in the S&P 500. The worst calendar year return was 0.0% in 1994, during which the S&P 500 gained 0.3%. And during the bear market of the past year, an average 25% investment in each of these four funds would have lost just 1.1% vs. a loss of 13% in the S&P 500.

In my next column, I'll discuss how these returns were estimated with the help of an Excel Spreadsheet, and show how returns can be optimized for different levels of risk. I'll also introduce a tool from Morningstar called Instant X-Ray to show how you can analyze the characteristics of a portfolio of mutual funds.

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