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Striking Balance in Your Portfolio
Fees a key issue

When it comes to balanced funds, industry analysts' opinions are split. Some analysts love them while others don't. I fall into the latter camp, often criticizing balanced funds because of high fees. This week, I'll review some of the problems with balanced funds, strategies for reducing fees, and some of the category's finer picks.

First, a primer on balanced funds. There are essentially two types - strategic and tactical. Strategic balanced funds are those that choose a long-term asset mix and stick to it, within some flexible ranges. Typically, such funds will hold about 40% in Canadian stocks, 20% in foreign stocks, and 40% in bonds and cash. On the other hand, tactical balanced (or asset allocation) funds tend to more actively manage the mix of stocks and fixed income based on the short-term outlook the manager holds for each asset class.

The average Canadian equity fund costs about 2.4% annually (i.e. MER: management expense ratio) and the average bond fund costs somewhere around 1.7% per year. Logically, the average balanced fund should cost about 2% a year, but in fact most balanced funds cost the same as Canadian equity funds - about 2.3% annually. Mid-term government bonds have a yield-to-maturity ranging from 5.8% to 6.3% annually. Do the math and you find that fund MERs eat up nearly 40% of a balance fund's bond yields. (For simplicity, I've ignored any positive or negative value added from a manager's bond trading.) That leaves you with a paltry 3.7% net yield on 40% of the portfolio - putting lots of pressure on the equity side to perform. Based on these figures, most balanced funds will have a hard time generating 7% per year over the next ten years.

The table below illustrates the point using AGF. Based strictly on MER differentials, one would expect AGF Canadian Balanced to underperform the unbundled approach by 0.2% each year. In our example however, the balanced fund underperformed by 0.4% per year. So it actually had a negative value added of 0.2% annually, when compared to buying the stock and bond funds separately. This is not a perfect test for two reasons. First, MERs change over time. Second, old funds are often merged into other funds if they are underperformers or fail to attract investors (i.e. survivorship bias). Despite these factors, this still provides a realistic picture of the impact of fees on balanced funds.

Invested on 7/31/1990 Value on 8/28/2000 Annualized Return Composite MER
AGF Cdn Stock $6,000      
AGF Cdn Bond $4,000      
Composite $10,000 $30,849 11.80% 2.30%
AGF Cdn Balanced $10,000 $29,640 11.40% 2.50%
Difference n/a   0.40% -0.20%

Thrifty investors can cut costs by much more by switching 60% of a balanced fund into a similar equity fund (usually same family) and using one of the following cheap alternatives for the 40% fixed income component:
  • low-fee bond funds like Perigee Index Plus Bond or PH&N bond;
  • Barclays' new exchange-traded bond funds (iG5 and iG10); or
  • a direct bond investment.
Despite all of the "trash talk", there truly are some great choices available in the category. Though there are other good alternatives, here are my top three picks for Canadian balanced funds:

Bissett Retirement
This fund is really a portfolio of other Bissett funds. While this fund has low fees, don't be fooled by the 0.21% MER - that excludes fees on the underlying funds. Actual fees are still just 1.3% - dirt cheap. Lead manager Michael Quinn leads a team that actively manages the mix of various funds. He has let the equity side continue to run, giving this fund an equity bias. Despite high valuations, Quinn still sees plenty of room to pick up attractively valued stocks. So have they added value? You bet. Since this fund's birth, it's performance net of fees has outpaced its benchmark's gross performance. That's a fact few funds can claim, making this one of the best true one-decision funds in Canada.

Fidelity Canadian Asset Allocation
Though fees seem high on this portfolio, this is one example where the extra cost may be worthwhile. Fidelity was ahead of the times when this fund was introduced because it's really a multi-manager approach - a hot concept today. Dick Habermann makes the big picture asset mix decisions, while specialists Alan Radlo (stocks) and Ford O'Neil (bonds) handle security selection. A gutsy decision to overweight stocks a few years ago, along with awesome stock picking have lead this fund to five straight calendar years of top quartile performance and a track record that has outpaced the benchmark by a healthy margin.

Perigee Symmetry Balanced
At the heart of this fund is a macro-driven approach that first looks at the Canadian economy from a fundamental standpoint, relative to its peers and studied in a historical context. Return expectations for stocks, bonds and cash are then formed, from which the asset mix decision evolves. On the stock side, the team practices a blended approach of growth and value. With a bottom-up focus, most of the research is handled in-house, rather than purchased from big brokerage houses (i.e. "the street"). If you're bullish on Canada, this fund may be for you. This teams forecasts an economic picture that overshadows that of the US - faster growth, lower inflation, a rising loonie, and higher share price growth. As a result, foreign content is about 13% of the fund. Awesome active management, low fees, and good diversification make this a gem in a category filled with mediocrity. One caveat: Nortel Networks accounts for 14% of the portfolio.

It's no secret I'm not a fan of balanced funds, so I rarely use them in portfolio recommendations. However, if you can't resist jumping into the "one stop" concept, the three funds highlighted above should provide good diversification, and a good mix of growth and safety.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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