Economics & Markets

Enhancing return outcomes of a traditional balanced fund

By Michael Gray
Head of Investments NZ New Zealand

As the end of 2021 quickly approaches, it is a good time to reflect and focus on what counts.

Although focusing on short to medium-term risks such as rising inflation pressures and the direction of central bank policy is important, it is the overarching investment strategy and construction of portfolios that ultimately drives investment outcomes over the medium to longer term.

In this light, the December 2021 edition of Portfolio Watch (AMP Capital’s monthly webinar) challenged the reputation of the traditional balanced fund of 60% equities and 40% fixed income. In doing so, we highlighted investment approaches that could potentially enhance investment outcomes of a balanced fund and smooth out investment returns over the economic and market cycle.

A balanced fund is more volatile than appreciated

Although the balanced fund has served investors well over time, it has had extended periods of underperformance. As shown in chart 1, ‘lost decades’ (highlighted by the shaded areas) of the US Balanced Fund (60% S&P500 Index and 40% US 10-Year Government Bond Index) occur on a relatively regular basis.

Arguably, if you had managed to stay invested in a balanced fund since the early 1990s, the investment experience has not been too bad – albeit this experience has come with a high level of volatility, as highlighted in chart 2.

Chart 1: Balanced funds ‘lost decades’

Source: Goldman Sachs Investment Research
Source: Goldman Sachs Investment Research

Chart 2 highlights that balanced funds have difficulty avoiding sharemarket corrections. Since the 1990s the balanced fund has experienced three major drawdowns, 2001, 2008/09, and 2020. These drawdowns usually coincide with recessions (the shaded areas in Chart 2). The notable exception being 1987. There have also been regular annual drawdowns of between 5-10%.

Chart 2: Volatility happens

Source: Schroders, Datastream
Source: Schroders, Datastream

The above analysis is consistent with a study undertaken by Deutsche Bank in 2012, ‘Rethinking Portfolio Construction and Risk Management’. The study highlighted that the balanced fund is risker than many might think. For instance, over the period 1900-2010, the balanced fund:

  • generated negative real returns over a rolling 10-year period for almost a quarter (22%) of the time • the worst year was a loss of -31%
  • on an annual basis experienced real negative returns one in every three years and returns worse than -10% one in every six years (real return is after inflation), and
  • equities dominate the risk of a 60/40 portfolio, accounting for over 90% of the risk in most countries.

The objective of this post is not to predict the next lost decade of the balanced fund but to highlight this type of fund is riskier than many people think and can experience long periods of underperformance. 

In addition, the current market environment does present some challenges for investors:

  • Global equity markets have experienced a very strong and sharp bounce from the Covid-19 lows of March 2020, and market valuations are stretched, particularly in the USA.
  • Interest rates around the world remain near historical lows, despite drifting higher in recent months.
  • At the same time, market fixed income indices have become riskier, as measured by increasing levels of duration and the narrowing of credit spreads.• This means the portfolio diversification benefits of fixed income within a balanced fund may not be as strong in the future as they have been over the last 30 years.

Enhancing the outcomes of a balanced fund

Over 2022 we hope to build on the above themes and outline strategies and approaches to enhance the investment outcomes of the traditional balanced fund that potentially provide a smoother ride for investors.

The Portfolio Watch presentation by Schroders (an underlying Manager in the AMP Capital Global Multi-Asset Fund) gave an overview of the challenges facing the traditional balanced fund approach and potential approaches to address these short comings. Among the approaches to enhance return outcomes is to increase asset class breadth within a portfolio (higher levels of portfolio diversification) by diversifying outside the traditional asset class categories.

As featured in chart 3, returns from asset classes vary over time relative to each other and no one asset class is consistently the best performer. Portfolio volatility can be reduced by not being overly reliant on a narrow group of asset classes.

Chart 3: Asset class returns

Source: Schroders Datastream as of 31 December 2020
Source: Schroders Datastream as of 31 December 2020

The market outcomes from chart 3 also highlight the potential from having a more flexible or dynamic investment approach to add value and seek a smoother return outcome over time.

Lastly, an alternative investment approach to a balanced fund is goals-based investing. Goals-based investing represents a shift in the way financial advice is given and the way investment solutions are designed. You can find out more on goals-based investing ‘How is it different?’ here

A goals-based investment strategy could form part of an allocation within a traditional fund as a way to provide portfolio diversification.

A total portfolio approach could also be taken.Investors that would benefit from a goals-based investment approach include:

  • those saving for retirement – the focus on the portfolio being appropriately managed throughout the life cycle
  • those in retirement – focusing on the primary goal of generating a stable and sustainable level of income in retirement
  • defined benefit plans – reducing volatility relative to member’s benefits
  • insurance companies – to assist the focus on meeting liabilities, managing capital and earning sufficient return on capital
  • Endowments, charities and family offices, positioning the investment strategy to support current spending programmes and to grow the investment portfolio to meet the requirements of future generations.

Goals-based investing reflects that modern day investment solutions increasingly involve greater customisation for customers. It recognises that for most investors investing is an individual experience – whether as a person saving for retirement or as an organisation meeting their investment objectives and liabilities. Also, different investors have different goals and circumstances which need to be considered when constructing a portfolio.

All the best for the festive season and 2022.

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Important notes

This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.

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