Benz: Some Favorite Balanced Funds

Jason Stipp: I'm Jason Stipp for Morningstar. Although, investors have a plethora of investment vehicles to choose from, some recent research from Morningstar showed that a veteran investment type, the balanced fund may actually be used better by more investors.

Here with me to explain that research and offer some of her favorite balanced funds is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, our director of fund research, Russ Kinnel, recently did a study that was looking at investor returns, and it showed some interesting things about lots of different investment types, but balanced funds in particular. What did that study find about those funds?

Benz: Well, it found that investors tended to use these funds relatively well. So, when we looked at the investor returns, which are essentially dollar-weighted returns that look at when flows come in and out of mutual funds, what they found was that balanced fund investors really got to hang on to a lot of the total returns that the funds generated, because they timed their purchases relatively well or more importantly, they probably hung on through those periods of relatively weak performance.

Stipp: So, you get a stated return when you look at a mutual fund's data page. These investor returns take into account when people got in and when they came out. So, even though a fund may have had a 50% return in one year, it doesn't mean that everybody captured that return, right?

Benz: That's exactly it, Jason. So, Russ looked at equity funds by contrast, and recently we've had this tremendous rally in equity funds. What Russ has found is that investors didn't get a full piece of the action, because what we've seen, by and large, is investors buying a lot of bond funds over the past few years. So, that was one category where investor behavior wasn't as fortuitous. In the case of balanced funds, it's actually been pretty good.

Stipp: So, you mentioned with the balanced funds investors maybe have held onto them, and didn't get out of them at the wrong time. What are some of the reasons why they have been used better by investors potentially?

<TRANSCRIPT>

Benz: It's hard to guess that what investors in aggregate are thinking, but one hunch we have is that, when you look at a balanced fund, this not a sexy category. So, investors aren't inspired by greed and fear. They will never have the hottest returns when you look at the leaders and laggards list, but nor will they ever really hit the skids, as pure equity funds did during the bear market. So, that relatively placid performance, I think, is not going to inspire those knee-jerk reactions to buy and sell. So, I think that's one reason.

Another thing I would point to you, Jason, is that these funds are mainstays in 401(k) plans. This is just a hunch, but one thing we see when we look at the data is that 401(k) investors are remarkably placid. They're inert, actually. They don't make many choices unless really prompted to. And so because these funds tend to big fixtures in 401(k) plans, my guess is that the 401(k) investors just aren't making rash decisions; they may not be making any decisions in relation to these funds.

Stipp: So, when you think of a balanced fund, you think of when they probably mixes some degree of equities with some degree of bonds, but there actually are different types of balanced funds. Can you explain some of the differences there?

Benz: It's a broad asset class, a term that we use and lot of people in the industry use. Within Morningstar, we have some official sub-categories that fall under that heading of "Balanced." So there is Conservative Allocation, these are funds that are mostly bonds, upwards of 50% in bonds; Moderate Allocation, those are funds that generally have a little more than 50% in equity, but not a lot more than, say, 70%; and then Aggressive Allocation, those would be funds that would be majority composed of equity.

So those would be some of the main categories. We also have a Retirement Income category that is primarily fixed-income-heavy funds, and of course, the target-date funds also fall under this "Balanced" heading.

Stipp: And within in those categories, some of the funds are managed in a different way as well. Can you talk about some of the variations of flavors, even within the different broad groupings that Morningstar has?

Benz: I would say there are really two major categories. One would be funds that stick with relatively static asset allocation mixes, and at this point, this is really the majority of this total balanced fund universe, funds that are not making big swings in their asset allocation.

But another sub-category and one that has garnered a lot of more interest recently would be funds that are using more active strategies in managing their asset allocations, the so-called tactical funds. The Rob Arnott funds, for example, that are going to be very active, where the manager is really looking at the whole opportunity set of asset classes and attempting to decide which are most or least attractive at any given point in time.

Stipp: So if you're looking at some of the different varieties of balanced funds, you're thinking about maybe investing in one, what are some of the downsides that you should think about? What might give you pause before you would jump into one of these funds?

Benz: Well, a couple of key things, Jason. First of all, not all firms are good at all asset classes. So, really there are only a handful of firms that we would say are equally as good at managing equities as are at fixed income. So, it's kind of a narrowed set right there. You need to be careful because you're putting a lot of your eggs in this one basket. So, that's one key thing to keep in mind.

Then also, if you are drawing income from your portfolio, you'd want to pair such a fund with a true cash-like vehicle, because these funds typically do have some equities in them. You wouldn't want your assets to be gyrating around while you're drawing portfolio income from it. So, you'd need to have a separate receptacle for your cash assets.

And finally, if you are someone who is just starting out, arguably the true balanced fund with maybe 40% of its assets in bonds is a little too safe for what your asset allocation should be. You are a person with a very long time horizon, you can afford to have a lot more in equities than that.

Stipp: And what about if I'm one of those so-called asset allocation purists, where I really want to know that I've got this percentage in bonds this percentage in equities. Would I want to steer clear of a balanced fund that might have a little bit of a range in those allocations.

Benz: Yes, by all means. That's a great point, Jason. So, one of these tactical more active asset allocators would definitely not be for you if you are someone who likes to stick with a prescribed asset allocation--you wouldn't want to have that more active fund in your portfolio.

Stipp: Because we already mentioned that these funds tend to be used better by investors because they offer generally a smoother ride. What are some of the other benefits of being in the fund like a balanced fund?

Benz: Well, I think, certainly, the ease of use and the flexibility and also just that low-maintenance hands-off aspect--the chance to get a lot of diversification in a single shot is very attractive.

And then the flip-side of the person who doesn't want someone being tactical on their behalf would be someone who wants a manger who is really surveying the whole investment universe and maybe making some of those more tactical decisions. For those folks, such a fund could be really quite appealing.

Stipp: So different types of investors may want to consider different types of balanced funds. There are different sorts of ways that the balanced funds are managed. What are some of your favorites on the more plain-vanilla side that have more static allocations and then also on the more active side, where they may be making some tactical decisions about their allocations?

Benz: Okay, so starting with the plain-vanilla funds; there are so many funds in this category that I like, but I would highlight a couple of Vanguard products. Tax-Managed Balanced is one that I've long liked. This is probably the most boring fund in the universe, but it is a pretty static asset mix. This one actually lands in our Conservative Allocation category, and it is a fund that is rebalanced for investors periodically, and management tries to do so in a tax-efficient way. So it's a good, core relatively conservative holding for a taxable portfolio.

Vanguard Balanced Index is also, I think, a nice low-frills offering. Our colleague, Jeff Ptak, has been looking at the universe of more tactical funds. What Jeff has found is that most of these tactical funds have had a very difficult time beating this very plain-vanilla Vanguard Balanced Index. So that's kind of the conservative static asset allocations.

On the more active side, a couple of funds I like would be FPA Crescent, using a deep-value strategy to navigate the stock and bond universes, and also these Manning & Napier funds are funds that our analysts have found very appealing--the Pro-Blend Conservative and Moderate versions are somewhat more active, also looking at kind of a whole toolkit, where the managers can buy international as well as domestic.

Stipp: And maybe (split any) difference a little bit, are there any more static allocations where they are doing some more hands-on active management in the bond side and in the stock side?

Benz: Yes, one firm I would highlight here would be Dodge & Cox Balanced. This is a fund that some investors were quite disappointed with its bear market performance in the equity side in particular, but Dodge continues to be a firm that we like a lot for that value-orientation that it brings to both its fixed-income and its equity research, as well as really low costs for all that active management. So, I think that that's kind of a good pick that lands somewhere in the middle.

Stipp: All right, Christine. Well, thanks for the context on the Balanced Funds and for those picks today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.