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Balanced Funds Today: A Balancing Act

By: Craig Fowler

Not all balanced funds are created equal, so investors are wise to work with a sophisticated manager of managers to help ensure that the best risk-adjusted returns are achieved, says Craig Fowler of Maritime Life.

When investors hear the term balanced fund, words such as safety, income, and capital appreciation likely come to mind. By definition, the purpose of balanced funds – sometimes called hybrid funds – is to provide investors with a single investment option that combines both growth and income objectives, by investing in both stocks (for growth) and bonds (for income). The idea here is that such diversified holdings ensure these funds will manage a decline in the stock market without too great a loss.

Indeed, over the past 10 years the median rate of return for balanced pooled funds (and their components) in Canada has been relatively consistent: 8.4 per cent for SEI Balanced Fund category; 8.4 per cent for the S&P/TSX composite index; 10.2 per cent for the S&P 500 (in US$); and, 8.3 per cent for the Scotia Capital Bond Universe Index.

There are times, however, when being in a balanced fund may not appear to make much sense. For instance, in 1999 and 2000, when some investors were reaping incredible returns in the high-tech market, those who weren’t cashing in on the euphoria wouldn’t have been making nearly the same level of returns. In this type of scenario, however, investors are wise to consider their financial goals, time horizon, and risk and reward profile. As well, timing is key. When you try to follow someone else’s lead, and adjust your portfolio to reflect the latest trends, chances are you’ll be too late.

The old lesson of taking a long-term view holds true for investors with little immediate cash needs. While the NASDAQ Composite Index, which is fairly tech heavy, returned nine per cent over the past 10 years, returns would have been much higher at the height of the high-tech mania. In comparison, investors in that index quite possibly lost money in the three years following the bursting of the tech bubble in mid-2000. Or, in 1994 when the U.S. Federal Reserve increased interest rates significantly, those with a heavy bond focus would have suffered substantially, but over a 10-year period they’d still come out with an 8.3 per cent annualized rate of return. Adopting a true balanced fund approach, and sticking to it, will let you participate in the best asset classes. Investors will leave some money on the table from time to time, but over a 10-year period, they will mitigate their risk and maximize their return based on the amount of risk they’re willing to take.

Taking It One Step Further

Still, there are more than one or two ways to construct a balanced fund. And what works for one investor, may not work for another. That’s why investors considering such a strategy are wise to adopt what’s known as a ‘manager of managers’ approach to balanced funds. Here, a third party service provider or vendor puts together a portfolio of fund managers with different investment approaches, helps investors pick a mix of managers whose styles complement each other, and monitors this mix over time, making adjustments as necessary.

Examples of the manager of managers strategy include picking a manager for his or her philosophy and using that person for both fixed income and equities; choosing one manager for the equity portion and another for the fixed portion of a portfolio; or choosing a specialist within asset classes, such as one for Canadian equities, one for international equities, and so on.

When constructing the total balanced fund using these approaches a sophisticated manager of managers will look to select managers whose styles complement each other and hence increase riskadjusted returns over the long term.

Some vendors also have pre-packaged portfolio options, with investors making their selection based on their risk and rewards profile. Each portfolio is optimized using forecasted returns, risk, and correlation. Each one is set up with a grouping of funds so that both asset classes don’t go up and down at the same time.

The Three Ps

When selecting a manager of managers’ product, you should be confident the vendor is focused on three key elements when selecting managers: process, people, and performance. The role of the vendor is to ensure that when managers say they’re following the three Ps, they’re actually doing so. And if something does go awry, the vendor is ready to act on it.

One of the misconceptions around selecting a manager is that performance is the sole trigger. It’s more important to ensure consistency of returns through a full market cycle. To get performance, you have to pay for it where additional risk usually ends up being the cost. Track record is one thing, but what did the manager do to get there and what risks did he or she take are much more important questions to ask.

Investment process relates to the style of the manager – is he or she a growth or value manager; is the approach top-down or bottom- up; does the manager stay true to his or her philosophy; what’s his or her buy and sell discipline, etc. If a manager of managers hears a manager bad mouthing a particular security or industry, for example, but the manager continues to buy it, he’s not following any specific conviction. In this case, it’s time for a change.

The final element – people – means a manager of managers monitors a situation to make sure the success of a fund isn’t contingent on one single individual. If something should happen to that person one day, what will happen to the fund? Managers of managers will look for firms that take a team approach and have an ownership structure that makes people want to work there over the long term.

As well, they’ll want to ensure that when a firm becomes very popular in terms of performance, and assets start flowing its way, the firm has the capacity to handle it or the business savvy to limit fund in flows.

Managers of managers should be talking to these managers every quarter. They will express concerns when applicable, and if the manager doesn’t address them, the manager of managers will make adjustments. It’s important that a manager of managers try not to overreact and make changes on a whim – this will only work to the detriment of the investor’s returns. What’s more, a true manager of managers makes decisions with thoughtful, careful consideration. If he keeps making changes, he didn’t do a good job in the first place. In other words, a manager of managers’ approach doesn’t mean there’s a revolving door of fund managers.

Taking a Position

No matter how you construct your portfolio, it’s always important to keep balance, diversification, and how different investment strategies correlate at top of mind. Investors need to have their own view of the market going forward. No one person will have the answer and no one knows how markets are going to react in the future. So, you have to take a position one way or the other in how you construct your investment portfolio.

As well, balanced funds are not all created equal. In addition to the typical 60/40 split, there are certainly other options, such as diversifying the equity portion among Canadian, international, and U.S. stocks, and/or having the manager of managers increase the fixed income or equity portion slightly depending on the perceived risk premium in the respective asset classes from time to time. For a balanced fund, working with a more sophisticated manager of managers who will create an optimal portfolio for your investment needs is often the way to go.

Regardless, investors must understand what they’re getting into, especially when it comes to risk. The level of risk tolerance investors take is very much a personal decision based upon that investor’s particular circumstances. You should make sure that potential losses aren’t going to keep you from sleeping at night. This is similar to taking prescription medicine, what works for one person doesn’t necessarily do the trick for the other.

Overall, a balanced fund, using a sophisticated manager of managers can provide a superior risk-adjusted return over the long term. Selecting a manager of managers who takes the time to understand your risk tolerances and investment objectives when constructing a balanced fund portfolio can go a long way to ensuring you achieve above average investment returns while ensuring you’re able to sleep at night.

Craig Fowler is vice-president, institutional investment markets, with Maritime Life.

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