Pay double attentions to balanced funds

Generally, equity funds and fixed income funds represent aggressive and conservative investments respectively. As for balanced funds......

YT Kum, CFA 08 October, 2007 | 0:00
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Generally, equity funds and fixed income funds represent aggressive and conservative investments respectively. As for balanced funds, not surprisingly, are somewhere between two extremes. In fact, investing in balanced funds is an easy way to construct a fund portfolio blending with both equity fund and bond fund. However, as balanced funds contain two different kinds of portfolios, investors should pay double attention to analyze them before making investment decisions.

Delving deeply into styles
Delving into funds' investment style is of the first importance in mutual fund investment. Here is a simple guideline to investigate the investment style of balanced fund: 1) to find out the equity/bon

d ratio; 2) to look into the style of equity portfolio and bond portfolio respectively; and 3) to know how equity portfolio manager and bond portfolio manager work together.

Compared with fixed income investment, equity investment is earmarked as investment with high expected return coupled with high risk, and thus the equity/bond ratio of balanced funds' portfolio plays a crucial role in evaluating their risk-adjusted returns. According to Morningstar's data as of August end, the average volatility (3-year) of Dollar Cautious Balanced Fund Category (with equity component <35 percent), Dollar Moderate Balanced Fund Category (with equity component <60 percent) and Dollar Aggressive Balanced Fund Category (with equity component <75 percent) are 3.12, 5.82 and 7.76 respectively, showing a clear trend that the higher the equity/bond ratio, the higher the risk is.

Looking into each tail
Investing in balanced fund is somewhat similar to investing in an equity fund and a bond fund at the same time; hence investors should well understand the investment style of each tail. Basically, investors can firstly look into the composition of the benchmark index, if any. For example, the benchmark index of Blackrock Global Allocation Fund composes of 36 percent S&P 500 , 24 percent FTSE World ex US, 24 percent ML US Treasury Current 5 year, 16 percent Citigroup Non-USD World Government Bond Index, dropping some hints to investors that its equity portfolio is quite US-centric and its bond portfolio focuses on sovereign issues, particularly in US treasury securities.

Other than looking into the benchmark indexes of balanced funds, investors can also get some idea about each manager's style and skill through other funds they are steering. For instance, the First State Asian Bridge Fund is co-managed by Martin Lau (equity portion) and Ken Hui (fixed income portion), where Martin Lau manages other four individual equity funds and Ken Hui is now the fund manager of First State Asian Bond Fund.

Moreover, investors can always analyze balanced funds by observing their portfolio breakdowns. For example, Templeton Global Balanced Fund, is co-managed by Peter Wilmshurst (equity portion) and Michael Hasenstab (fixed income portion). Scrutinizing its bond portfolio as of July end, it invests in some emerging market issues, like Malaysia (3 percent), Poland (3 percent) and South Korea bonds (3 percent), which behave like growth drivers instead of fund's guards; as for equity portfolio, it mainly focuses on industry behemoths with high yields and stable growth, which act like a fund's guard rather than a spearhead. Figuring out the growth drivers of a fund is important for evaluating the risk factors. In this case, investors should pay more attention to the risks associated with the fixed income portfolio management.

How portfolio managers work together
There is a simple question to investors: what is the difference between investing in a single balanced fund and investing in an equity fund and a bond fund at the same time? It depends on how fund managers co-operate.

For some balanced funds, they simply cut the portfolios into two slices and manage them separately. In this case, the only co-operation opportunity between portfolio managers is portfolio re-balancing. In this regards, putting aside the re-balancing, purchasing this kind of balanced fund is very similar to investing in two separate portfolios concurrently. However, re-balancing makes a difference. For instance, if the equity/bond ratio of a balanced fund portfolio is 60 percent equities and 40 percent bonds and the deviation from target is within 10 percent. When equity market goes up and bond's performance is lackluster, the fund management may have to sell stocks to buy bonds in order to bring the asset allocation back into the line. Although rebalancing could help investors to control portfolio risk, it may also limit portfolio returns if equities are riding on a strong uptrend.

There are also some balanced funds where managers have great flexibility in adjusting the equity/bond ratio according to the market situation from time to time. When management is positive towards equities, they can increase the equity portion to capture profits; when they become bearish, they can raise the bond portion to reduce risk. This style is more flexible and responsive to market changes, but its success is heavily depended on the skill sets of fund managements, where investors should pay particularly attention at this point. Investec Strategic Managed Fund and Schroder Global Emerging Market Opportunities are two of many examples who adopt this strategy.

After digging into balanced funds' investment styles, investors should consider another question: what role a balanced fund should play in your portfolio? Particularly if you have already constructed a "balanced portfolio" on your own.

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About Author

YT Kum, CFA  YT Kum is a consultant for Morningstar, contributing to manager selection and asset allocation activities in Asia, and is responsible for providing investment thought leadership on topics relevant to investors in Asia.

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