So-called ‘balanced funds’ performed well over the last two decades, says Nick Samouilhan, multi-asset manager at Aviva Investors. But the gilts argument is history now, and we need to rethink our plans.
Building balanced, diversified portfolios was easier in the past than it is now. Take, for instance, the common allocation split of 60 per cent equities and 40 per cent gilts for balanced funds. Those funds, while simple, managed to provide strong returns, low volatility and few significant drawdowns for clients over the past 20 years.
Understanding Balanced Funds
The key to the successful performance of balanced funds provided by their allocation between equities and bonds was partly the equity component. However, the major explanation to their success was their allocation to government bonds – specifically gilts.
While equity provided the core growth engine, gilts played three different roles in the portfolios. Understanding these helps show how they provided protection, income and returns to portfolios and why they are unlikely to do so in the future.
Firstly, gilts provided strong returns due to a background of falling inflation and interest rates, which move in the opposite direction to bond yields. Secondly, reasonably high interest rates on bonds allowed funds to ‘tick along’, earning a return even if nothing happened. Lastly, given the high level of yields, bonds were able to provide significant capital protection to portfolios during risk-off market environments.
The key message to keep in mind here is whether all three of the above factors will still apply in the future. For instance, government bonds are currently priced at a level where all three of these factors will be hard to achieve with them.
Firstly, low single-digit yields reduce the running yield they provide. While still positive, this carry aspect is significantly less positive than in the past. Secondly, the long period of falling yields and inflation looks to have come to an end (rates cannot permanently fall below zero) limiting capital growth prospects. Finally, low yields mean the scope for protection during a negative environment is very limited.
An Alternative Approach
How should fund managers respond to the changing environment for balanced funds? The main point is there is no single asset class that provides all of the above attributes like gilts did in the past. As such, portfolios need to become much more diverse to provide the same objective as they did in the past.
For example, to provide income credit (eg corporate bonds, high yield and emerging-market debt) are useful candidates. For growth, equities remain the best asset class for long-term growth, particularly given relative valuations to other asset classes. Finally, for capital protection gilts still help but far less so than previously.
So, more complex investment strategies must be employed to combine suitable types of investment to provide the performance clients want with balanced portfolios. What is needed is a strategy that provides value during a negative environment while not costing too much during a normal environment. Here, currencies such as the dollar are possible candidates, likely to rally in a risk-off environment.