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NEW YORK (TheStreet) -- Folio Investing, an online broker, has been crowing about its target-date retirement portfolios. Folio says that most of its portfolios have outperformed competitors by wide margins. According to Morningstar, the average 2020 target-date mutual fund returned 1.3% annually during the past three years. In comparison, Folio says that its conservative 2020 portfolio returned 3.4%. Folio attributes the success to a bold strategy that ignores traditional rules for diversification and asset allocation.

The Folio investments are not mutual funds. Instead, they are baskets of ETFs. To invest in one of the Folio target-date portfolios, you must open a brokerage account at the company. Retail investors can maintain an account for a flat annual fee of $290.

Can Folio continue delivering competitive returns in the future? That is difficult to know because the track record is still short. For the time being, most investors may feel more comfortable with one of the conventional target-date mutual funds. But the Folio offerings are worth watching to see if they can demonstrate a new way to manage retirement savings.

Target-date funds are designed to serve people who plan to retire around specific dates, such as 2020 or 2040. The funds are broadly diversified, including mixes of stocks and bonds. As the retirement date approaches, the portfolios become more conservative, aiming to avoid losses.

The target-date category is dominated by large fund companies, including Fidelity Investments, Vanguard Group, and

T. Rowe Price

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. Though each company has a slightly different strategy, all the major competitors agree on basic approaches. The funds emphasize core holdings that include large-cap stocks and investment-grade bonds. As the retirement date approaches, the bond allocation increases and equity holdings are reduced.

While the major companies provide broad market coverage, Folio's target-date portfolios invest in niche ETFs. To appreciate how the major companies differ from Folio, compare

Vanguard Target Retirement 2040

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, which returned 1.3% annually during the past three years, and Folio's moderate 2040 portfolio, which returned 1.5%. The Vanguard fund has about 62% of assets in

Vanguard Total Stock Market Index

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, a broad index that fits in the large blend box, 26% in

Vanguard Total International Stock Index

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and 10% in

Vanguard Total Bond Market II Index

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In contrast, the Folio target-date portfolio has an unusual collection of 10 holdings, including 5% of assets in

iShares MSCI Malaysia

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, 5% in

Vanguard Utilities

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and 10% in

Vanguard Index REIT

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. Folio executives argue that their approach provides greater diversification because the niche ETFs do not move in unison.

Folio managers say that they have avoided general large-cap stock funds. The managers argue that they can get better diversification with a mix of assets that includes ETFs specializing in utilities and other infrastructure stocks.

Even during downturns, consumers spend on electricity and transportation, so infrastructure stocks sometimes prove resilient. Folio portfolios also hold commodities and emerging market stocks. Those can be volatile, but they tend to have low correlations with other assets.

Defending their approach, the Folio managers point to the experience of the financial crisis when stocks of all kinds fell. Some target-date funds lost almost as much as the

S&P 500

because bond holdings failed to cushion the losses suffered by stocks.

"Many designers of target-date funds assume that if you own a domestic stock fund and a foreign stock fund, then you are diversified," says Greg Vigrass, president of Folio Institutional. "But you need to hold a wide range of assets."

The Folio approach showed promise during the downturn of 2008. For the year, Folio 2040 lost 30.8%, while the Vanguard 2040 lost 34.5%. Vigrass argues that his portfolio outperformed because it was more broadly diversified, not because the Folio investment held more bonds or other staid investments.

Target-date mutual funds have glide paths, long-term plans for lowering stock allocation. A typical glide path for a 2040 fund would show that the portfolio begins with 90% of assets in stocks and reduces the allocation to 50% during the next 30 years. With Folio investments, the glide path is less certain. Each year, Folio reviews market conditions and adjusts portfolios. The idea is that correlations can change. Assets that appeared safe in the past may become riskier.

In 2010, Folio lowered its allocation to Treasury Inflation-Protected Securities. The problem was that the securities were becoming more correlated with stocks and providing less diversification.

To determine portfolio holdings, Folio runs thousands of Monte Carlo simulations. These test how different assets might perform in various market conditions. The aim is to find the combination of assets that seems most likely to produce the best returns, while taking an acceptable level of risk.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.