I have been a believer in balanced funds for many years now. The simple balanced fund offers investors good exposure to growth assets, and lower volatility than the market. A well run balanced fund can outperform the equity market over time if the manager is able to get asset allocation right. Numerous balanced funds have long term track records with better than market returns so it possible. The rise of passive balanced funds has added an additional dimension to the market as investors can now access the benefits of balanced funds at a fraction of the cost that most active managers charge.

A few weeks back I sat for an annual portfolio review with a client. He has been a client for three years and like many investors, was concerned about lower than expected returns over the period. After the usual discussion around market conditions, he asked for a bit more analysis. He wanted a comparison of his portfolio relative to the relevant unit trust sector as well as the asset classes. The discussion revolved largely around his preservation fund, so the appropriate sector for comparison was the multi asset – high equity category, the category where most balanced funds sit. Fortunately for us his portfolio had done relatively well compared to the sector, but something in the analysis caught my attention.

From the graph below you see that balanced funds have, on average, underperformed equities, cash, bonds and listed property over the past three years. This surprised me somewhat as balanced funds are able to allocate between sectors, and over most medium to long term periods return lower than the growth assets (equities and property) but above income assets (bonds and cash). There should also be some ‘return’ from manager skill as the manager moves between the asset classes; at least that is what is often offered to investors in the marketing material.

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It must be noted that this has not been the experience for the majority of investors in the sector as the ‘big 5’ balanced funds outperformed the average and equities over the period, although not by a worthwhile margin. Sector leaders over the period, Centaur and Bridge, fared significantly better with the former delivering a solid 42% return over the period. That is more than double the sector average. This highlights one shortfall of simply looking at the average. However, given the sheer size of the sector, and that the bulk of investors’ pension monies are invested here, it is not unreasonable to expect that, on average, the sector should outperform at least one of the asset classes. So why would there be this underperformance of all the asset classes over the past three years?

Fees

In a low return environment fees become a significant factor in terms of performance. It is unsurprising that the passive balanced funds with 3 year track records all outperformed the sector average over the past 3 years, after fees. A fund with a 1.5% p.a. fee would have needed to have delivered over 25% over the period before fees in order to underperform cash on an after fee basis. There are numerous funds with TIC’s (total investment charge) of over 2%. I think that fees have been a major contributor to this underperformance at a category average level. Passive balanced funds would have had to return 22% to deliver similar underperformance to cash as their expensive active counterparts.

Asset Allocation

Multi asset funds, including balanced funds, in South Africa had a 5% exposure to listed properties at the end of December 2016. Fund managers have been chronically underweight listed property for many years. This has led to investors losing out on the excess returns provided by the asset class for an extended period of time. Fund managers have consistently called the listed property sector wrong, and have costed investors potentially billions of Rands in returns over the past 15 years. This is one of the reasons passive balanced funds have outperformed as the managers there do not take a view on the asset class. Most passive balanced funds have had between 5% and 10% exposure to listed property. Managers like Bridge that have a strategic high property exposure have done exceptionally well over the past three years.

The other area where asset managers have failed investors has been in getting the asset calls wrong. Many funds underperformed in 2016 as managers continued with the momentum trade of 2012 – 2015, with lots of Rand hedge industrials and maximum offshore exposure. Boutique managers like Bridge, Obsidian and ClucasGray’s Equilibrium fund are examples of active managers that were positioned for a stronger Rand in 2016.

Conclusion

The picture over the longer term does look a lot better as the average balanced fund has managed to outperform cash and bonds, but underperform equities and listed property. However, if the current volatile market conditions persist much longer it could be harder for expensive balanced funds to deliver value to investors. I do not think that balanced funds are broken – yet. I think that investors need to pay more attention to some of the details like fees and asset allocation a bit more. Simply avoiding expensive funds is half the battle won!!

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