The hot product to–day is a balanced mutual fund. Balanced fund sales soared in 2009, comprising almost two-thirds of net long-term fund sales, as equity funds suffered net redemptions. At the end of 2009, assets under management in balanced funds totalled $230 billion, almost 40% of total mutual fund AUM. Balanced funds have more than doubled their share of mutual fund AUM over the past decade — in 2000, balanced funds comprised only 16% of AUM.

The popularity of Canadian balanced funds is easy to understand. The turbulence of equity funds through both the tech wreck and the most recent global credit crisis has rocked investors. Balanced funds containing a blend of bonds and stocks have offered more stable performance during this turmoil.

To gain greater insights into this performance, my firm, Tacita Capital Inc. of Toronto, analyzed three balanced portfolio models from January 2000 to December 2009. These were composed of varying allocations of Canadian bonds, as measured by the DEX universal bond index, and stocks, as measured by the S&P/TSX composite index. All portfolios were rebalanced annually. The models were:

> equities-tilted, comprising 75% stocks and 25% bonds

> neutral, comprising 50% of each asset class

> and bond-tilted, containing 75% bonds and 25% stocks.

Over the past decade, the bond-tilted portfolio was the superior performer, with an annualized return of 6.7% vs 6.6% for the neutral portfolio and 6.2% for the equities-tilted portfolio.

The stronger performance of bonds over the past decade (with a 6.7% annual return) as compared to stocks (5.6%) put more conservative balanced funds into first place. Although stocks typically lead over a 10-year period, bonds outperform more frequently than one might imagine. In 13 of the 75 rolling periods of 10 years since 1926, intermediate government bonds in the U.S. have outperformed the S&P 500. That’s almost 20% of the time.

There was a big difference in the turbulence of the ride. The annualized standard deviation for the bond-tilted portfolio was 5.4%, a much more stable experience than the 9% and 13.2% standard deviations for the neutral and equities-tilted portfolios, respectively.

The worst drawdown experience (i.e., peak-to-trough loss, measured at monthend) was even more dramatic. The worst drawdown by the bond-tilted portfolio was 9.5%, vs 21.6% and 32.9% for the neutral and equities-tilted portfolios, respectively. All three portfolios, however, buffered investors from the 43.4% worst-case drawdown — by Canadian stocks. No wonder investors favour balanced funds.

Unfortunately, investors’ timing couldn’t be worse. Declining inflation has reduced the yield to maturity of a 10-year Canadian government bond from 6.4% in January 2000 to 3.5% in February 2009. The disinflation wind that had propelled bonds and thus balanced funds into the winner’s circle is yesterday’s news. Also, with credit spreads tightening, even investment-grade corporate bonds are yielding less than 4% today.

Contrast these yields to management expense ratios that are in the 2.5% range for many balanced funds. There is just not enough return potential in the bond component of balanced funds today — particularly, conservative balanced funds — to warrant their popularity.

Financial advisors should be implementing the bond and stock components of a portfolio separately. Bond exchange-traded funds with MERs as low as 0.15% are available today for the fixed-income allocation. For smaller clients where ETF usage is not warranted, stick with low-cost balanced funds. IE



Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment counselling firm. The firm, its principals, employees and clients may own securities mentioned in this column.