One of the principles for successful investing is to have an investing strategy. Many common strategies are based on the time horizon that an investor has until their goal. For investors with a long investment horizon, a portfolio geared towards equity investments, like stocks, is considered to be a sound strategy because their goal should be towards consistent growth. Investors with a short time horizon will typically move a large portion of their portfolio away from stocks and towards safer havens such as bonds and cash.
Within each of these timelines, there are other considerations such as risk tolerance and diversification. This is why mutual funds and exchange-traded funds (ETFs) have become so popular. Rather than requiring investors to choose individual stocks, these funds choose a diverse range (referred to as a “basket”) of various securities. There are many mutual fund families that focus on different risk tolerances from very conservative funds to very aggressive funds.
Within those investment philosophies (conservative, moderate, aggressive) there are even more choices. In fact, the whole mutual fund universe is like a Baskin-Robbins on steroids. Between index funds and ETFs, there truly is a fund for almost every kind of investor. But the problem is that not every investor needs all these options. Younger investors with a long timeline until retirement and who are comfortable with the volatility of stocks may choose to invest in individual stocks and if they do invest in mutual funds, they will probably only look at the aggressive options.
On the other hand, investors who are at or near retirement may be looking to limit their exposure to equities or eliminate it altogether. For them, they would be looking at the most conservative options and perhaps even exclusively bond funds or money markets.
However, many investors don’t fit neatly into either long-term or short-term timelines. Nor do they have a “one size fits all” risk tolerance. For these “intermediate” investors, finding the right mix of equities and bonds can be challenging. Being too heavy into equities may put too much risk into a portfolio. However, being too exposed to bonds may not leave your portfolio with enough room for growth.
This is where a specific type of mutual fund comes into play, a balanced fund. In this article, we’ll review what a balanced fund is and why their lack of complexity makes them a great investment option. We’ll also review the advantages and disadvantages of a balanced fund.
What is a balanced fund?
A balanced fund is a kind of mutual fund that has a mix of both equities (such as stocks or commodities) and bonds. In some cases, they may also include cash. It is considered an investment option for investors with an intermediate timeline (i.e. an investor who has several years before they will need the money from the fund, but they have made enough money that it is time to start protecting their profits.)
The most common mix of stocks to bonds in a balanced fund is 60% stocks/40% bonds. However, in recent years, many fund providers have begun to introduce new funds with a variety of balanced options. Although investors cannot “fine tune” a fund’s investment mix (i.e. 68% equity/32% stock) they generally have more options than a straight 60/40 mix.
Morningstar for instance now has broadened their description of balanced fund categories from three (conservative, moderate, aggressive) to five. The new categories are based on the allocation of equity:
- 15-30% equity
- 30-50% equity
- 50-70% equity
- 70-85% equity
- 85%+ equity
This is being done because there are many different kinds of balanced mutual funds including “funds of funds” which means a fund that contains a basket of other balanced funds. On the one hand, this is an improvement over listing just the general investing approach of the fund. After all, a fund that has a 30-50% equity profile may be considered a conservative fund, but not to the investor who is uncomfortable with more than 25% of their portfolio in equities. The disadvantage is that investors don’t really know what the percentage of equity refers to. For example, an investor may see two funds that are both rated for 85%+ equity. However, one may be limited to U.S. equities where the other may have exposure to international securities. Or one may include commodities while the other does not. That changes the risk profile entirely (and potentially the reward as well).
The other limitation that this naming convention does not address is the number of holdings that are in bonds and/or cash. Some funds will allocate some or, in rare cases all, of their bond exposure into cash (i.e. money market funds). Since cash is generating no interest at this time, knowing what percent of the fund was invested in cash would be important for an investor to know.
A balanced fund is not complex and that’s good.
A common marketing phrase when trying to generate interest in a mature brand is “This isn’t your father’s …” meaning that there’s something new and different about it. In the case of balanced funds, although investors may have a bit more variety in the equity-to-bond ratio of a given fund, these pretty much are the same funds that your father or grandfather may have invested in. After all, the first balanced fund came into existence in 1929.
But for an investor who may think that a stodgy balanced fund might be negative, consider this. When investors put money into a fund that promises an aggressive return, they may buy or sell frequently. And unless they're blessed with impeccable market timing that usually means that they will find themselves having an actual return that's much worse than the fund's total return.
But a person that invests in a balanced fund tends to be more patient. Call it a case of managed expectations, but when you expect a “Goldilocks” return (not too high, not too low), you’re psychologically more prepared to ride out the bad times and not overthink the good times. As a result of buying and holding, balanced fund investors usually see that their actual return is well in line with the fund’s total return.
What are the benefits of a balanced fund?
The largest benefit of a balanced fund is convenience. Just as a mutual fund helps take the guesswork out of selecting individual securities, a balanced fund takes the guesswork out of dividing your portfolio among a variety of mutual funds. Another benefit is diversification. By definition, a balanced fund will even out risk (and reward) and keep your portfolio divided evenly among stocks and bonds.
A balanced fund can be actively managed or passively managed. When a balanced fund is passively managed it means that the fund is set to an index or particular market sector. However, when a balanced fund is actively managed it creates another potential benefit because all of the securities in the fund are selected by a fund manager. These fund managers typically have the ability to choose what they perceive to be the best investments across all kinds of securities (stocks, bonds, and even commodities). This introduces the potential for a higher reward as these fund managers can react to changes in particular securities. However, depending on your risk tolerance, the idea of a fund manager that can truly “invest in anything” may not be a desirable solution.
This introduces another benefit of a balanced fund. Although the fund manager may have the flexibility to change the asset mix, they must maintain the integrity of the asset percentages. Every investor should understand the importance of rebalancing their portfolio. A balanced fund will always maintain its balance, even if some of the individual components are swapped out. If the fund is listed as a 60% equity/40% bond fund it will always maintain that 60/40 split.
What are the disadvantages of a balanced fund?
The largest disadvantage for balanced funds is the fees that they charge. Although they are not exclusively stock funds, they often charge fees as if they were. When you consider that balanced funds can be weighted 40% in bonds or more, investors have to consider if they would be better off in an actively managed bond fund as fees can impact the already low expected returns in bond investing.
Another potential disadvantage that was already mentioned is that some balanced funds have a portion dedicated to cash assets. In some cases, the amount of cash may take the place of bond investing. However, if the fund charges a fee of 1.5% on an asset that generates a 0% return, then it is actually costing an investor money to be in that fund.
As we mentioned above, many investors like the idea of having a single person managing their funds. However, if an investor prefers to manage their own fund allocation, a balanced fund can be problematic. This is because, in a typical balanced fund, a manager has the latitude to change allocations quickly and as they see fit. This can mean the fund's composition can change dramatically and can put an investor out of line with their objectives.
Finally, there is due diligence. If an investor puts money into an index fund that tracks the S&P 500, they have a good idea of exactly what they’re investing in. On the contrary, when investing in a balanced fund, investors will need to look into the prospectus to see what particular assets, securities, or even funds, are contained within the balanced fund.
The bottom line on balanced funds
In an investing culture of targeted funds and niche securities, balanced funds are a throwback to a simpler time, but are also proof that sometimes the simplest option is the best option.
A balanced fund is, as its name implies, a fund that balances the growth of equities with the relative security and safety of bond investing. The most common ratio for balanced funds is 60% equity and 40% bonds. To help attract investors with different risk tolerances, some balanced funds now offer varying degrees of equity. A balanced fund can be actively or passively managed.
The benefits of a balanced fund are largely due to their convenience and the way they offer an automatic way to diversify an account. Since a fund always has to maintain its equity-to-bond ratio, investing in a balanced fund will not require any rebalancing on an investor's part.
Another advantage for owners of an actively managed balanced fund is having a single fund manager to oversee and, when necessary, make adjustments to the fund mix. However, what some investors may see as an advantage, other investors may view as a negative. Since most fund managers have the authority to make changes to the fund without notice, changes can happen very quickly and can put a fund out of alignment with an investor’s objectives.
But the largest disadvantage to balanced funds is the fees, which are frequently similar to the fees charged by pure stock funds. As you can imagine, if the fund has significant bond exposure than even a 1.5% fee can have an impact on your actual return. This is amplified even more when a fund puts some of your investment into cash.