Why balanced funds are still relevant

Michael Hughes

Senior Vice President & Client Portfolio Manager - GuardCap Asset Management Limited


Andrew Osterback

CFA, Director, Portfolio Manager, Fixed Income – Canada


In a market with all the makings of a downturn, many are questioning the efficacy of a traditional 60/40 split between equities and fixed income. According to veteran bond expert Andrew Osterback, Portfolio Manager, BMO Global Asset Management, the true challenge is knowing where in the investment universe to allocate. Together with equity commentary from Michael Hughes, Portfolio Manager, Guardian Capital, the argument is that conventional bonds remain what they have always been – reliable.

Betting on government bonds

“Defensive” is perhaps the foremost concept that comes to mind when speaking of balanced funds. For our part, we tend to use fixed income as portfolio insurance in our BMO Concentrated Global Balanced Fund, helping us prepare for the long haul and protect against downside risk.

It’s important to note that our approach focuses strictly on the government universe. This mandate of Canadian federal and provincial bonds – which have historically been good diversifiers – distinguishes us from competitors who hold corporate credit as well. To be clear, while a third of strategies in the market hold private sector debt, we hold none. The idea here is that we play it safe, allowing the GuardCap team enough flexibility to choose 25 to 30 stocks that will generate higher returns across the cycle.

This narrow mandate is critical due to the presence of highly leveraged sectors on the equity side, and their impact on the composition of corporate bond holdings. If you split the universe and look at credit rating migration over the last five to 20 years, it’s crystal clear that the corporate quality has deteriorated faster than government creditworthiness. This has happened even as spreads tightened, which means investors are in general getting less reward for more risk.

Source: Morningstar DirectSM, as of October 5, 2020.

Finding faith in fixed income

To illustrate our approach to the government bond universe, it helps to look back at the first quarter of this year. As the pandemic became a rising concern, long provincial bonds rolled up the curve between the 20- to 30-year differential, and while there was value to be had the widening came with additional risk that we were not getting paid to own. As a result, we sold off provincials in favour of federal bonds, which provided the portfolio with much needed stability during those tumultuous weeks.  

In essence, we adhered to the defensive mandate for fixed income securities, and pulled back on areas we were not thrilled by. However, as we progressed to Q2, we started to buy back some of that exposure because spreads had widened too far, in our view, signalling a need to put some of that risk back in the portfolio while staying modestly defensive. That’s where we are today – with fixed income tilted towards provincials, which to us represents the risk that would normally be on offer through corporate credit.

We should note our decision came before the Bank of Canada (BoC) announced its buyback program, in which BMO Global Asset Management was awarded the contract to make provincial bond purchases on behalf of the central bank. We did this with the reasonable expectation that we may be wrong for a while, but that building into risk would inevitably deliver value.

Equities for the long term

For approximately 60% of the Balanced Fund, the first quarter of 2020, particularly March, was the perfect setting to do what it is meant to do – offer downside protection in a volatile market. The equity strategy performed so strongly that it beat the benchmark by over seven percent.

In the post March 23 period, as markets turned bullish again, the strategy continued to hold up relative to the index. This too was in line with its long-term characteristics. When markets were rallying in 2019, we outperformed; and in 2018 when the broad market was down nearly nine percent in US dollar terms, we were up by two and half points. Over time this approach has allowed investors to offset some of the near-term declines, and then continue to participate in growth when the market goes up.

Longevity is another critical part of the strategy. At least three companies have been in the portfolio for over 20 years, and overall the stocks in our equity strategy have already been invested in for a weighted average for equity holdings is approximately nine years. Importantly, every firm in our portfolio is engaged in industries that have long-term secular growth trends behind them, making them less prone to get blown off course if there are economic headwinds.

This explains why we have never held a mining company or an oil major, or steel, chemicals, automotive, airlines and so on. No two crises are the same, of course, but the usual suspects often do the worst under duress, and are hence missing in this portfolio – in this respect, the current crisis is much like the others.

With regards to the pandemic, the portfolio has undergone minor changes. One area we bowed out of was physical retail, including two holdings on two ends of the spectrum – one high-end, and the other a combination of high-end and affordable.

Putting stocks under the microscope

Although technology companies provide exciting fodder for analyst commentary, we only hold mega-cap players in the space. Take Alphabet, for example, which has at least 10 great products used in daily life. From Gmail to YouTube, it is sufficiently well diversified to sustain performance even if any one business line flounders. At the same time, it has a dominant market position within digital advertising, which is one of the long-term secular trends we always look for.

We also operate with the understanding that companies with sustainable growth tend to have sustainable practices. For example, if an enterprise is polluting the environment, or if its suppliers are employing people in sweatshop conditions, or the CEO treats the firm as his own empire, then chances are the long-term outlook is poor. To this end, our equity strategy omits certain sectors: tobacco, gambling, pornography, “predatory” lending, munitions and any kind of extractive industry.

As a result, the portfolio earns a strong ESG rating despite not being specifically a “green” fund. While we don’t invest in companies that indulge in unsustainable business practices, there is always room for improvement and our ongoing program of company meetings (or virtual meetings) gives us the opportunity to engage with the leadership if we think improvements can still be made.

Much of our thinking is informed by our proprietary DORA reports (“days out researching anything”), which look at various moonshot trends, from digitization to solar energy to edge computing. All of these secular changes have the potential to influence our equity strategy, especially given our belief that if you take care of the long-term, the short-term will take care of itself. We have been doing DORA days since February 2015 and now have a body of over 80 papers which, taken together, represent a kind of “manual of the future” and enable us to “future-proof” our portfolio.

Why Balanced, and why now?

Put simply, the benefit of our balanced approach is it offers the widest degree of latitude in picking stocks, without the impact of corporate risk on the fixed income side. Moreover, the fund’s defensive qualities are a natural fit for many, if not most, retirees and near-retirees. Case in point: approximately 20% of mutual funds assets fall in the balanced category, making it table stakes to have on your shelf when attracting new investors to your practice.

Of the two sides of the coin, the equity strategy is perhaps more easily understood, whereas it can be more challenging to wrap one’s mind around the fixed income component. If you plan on educating clients as to the benefits of government bonds versus corporate credit, keep in mind that the two big levers at your disposal are rates and the shape of the yield curve.  

For instance, in the near term the BoC policy will largely drive the front end of the yield curve, while inflation expectations will influence the long end. Moreover, based on the prevailing macro conditions and forward guidance available, it’s unlikely that we will see any difference in conventional monetary policy for a while. So now all we really need to track is what may happen with the future rate of inflation, which history tells us is going to be stable.

Preferred measures of core inflation: Year-over-year percentage change

Overall, the consensus right now is on playing the long game. Whether investors want to capture some quick wins in the process, or look beyond the near-term volatility, having a balanced strategy in the portfolio will mean they are protected from what could be a drawn-out period of peaks and troughs.


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