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portfolio strategy

The ETF industry won't seriously challenge the supremacy of the mutual fund until it develops an alternative to the humble, but hugely popular balanced fund.

Balanced funds are a blend of stocks, bonds and sometimes other investments such as preferred shares and real estate. They're a convenient way for investors and advisers to diversify portfolios and they sell like nobody's business. In the first nine months of the year, members of the Investment Funds Institute of Canada reported $21.6-billion in net sales of balanced funds. Net sales of individual equity and bond funds together came to just $15.3-billion.

The exchange-traded fund business seems to have a balanced-fund blind spot. There's a growing contingent of ETFs that function like balanced funds, but no concerted attempt to reach out to investors who are paying the often hefty fees charged by balanced mutual funds. The lack of balanced funds has to be considered among the reasons why there is $1.4-trillion invested in mutual funds and $141-billion in ETFs.

There may be some industry arrogance behind the lack of balanced ETFs. ETF companies seem reluctant to reach out to the often unsophisticated investors who buy balanced funds. Instead, they target a more sophisticated investor who wants to mix individual ETFs. Even when ETF companies do offer balanced funds, they don't use that term.

An early experiment with balanced ETFs may have failed because of this lack of interest in engaging the sort of investors who typically use balanced funds. BlackRock Canada's iShares division recently closed four "portfolio builder" funds with target audiences that included conservative and growth investors as well as people looking for alternative investments and global content.

Available for years, the portfolio builder funds never attracted much of a following. There's nothing unworthy about a balanced fund, though. Built right, it can offer simple, efficient, low-cost diversification, which is the foundation on which effective portfolios are built.

Here are four things to be aware of when considering one of the emerging cohort of balanced ETFs:

1. Fees

Balanced mutual funds typically have a management expense ratio (MER) in the area of 2 per cent or more, which is a lot in today's investing environment. The yield on the five-year Government of Canada bond is still around 1.6 per cent these days, even after a run-up this year. Most balanced funds have a significant weighting in bonds.

Balanced ETFs are not the amazing, low-fee bargain of their siblings that track indexes such as the S&P/TSX composite and S&P 500, where MERs can be as low as 0.06 per cent. But as the table shows, fees for balanced-fund ETFs are much lower than for comparable mutual funds.

Expect to find other ETFs as a holding in balanced ETFs. The published MER for a balanced fund should include the fees of the ETFs in the portfolio, unless noted otherwise.

The full fee picture for ETF investing has to factor in stock-trading commissions as well (ETFs are bought and sold like a stock). Figure on a bit under $10 a buy or sell, unless you use one of the few brokers to waive commissions on ETF purchases (you pay to sell).

2. Taxes

A subset of balanced ETFs and mutual funds are designed to pay monthly income derived from a portfolio of bonds and dividend stocks. For tax reasons, you'll want to pay attention to the exact composition of these monthly payouts in a non-registered account.

Expect to have a component of dividend income (Canadian dividends are eligible for the dividend tax credit) and regular income from bonds. Funds paying monthly income also typically include a return of capital in their payouts.

Return of capital refers to cash over and above the taxable income generated by the investments in a fund. You don't pay taxes on a return of capital in the year it's received. Instead, the amount is subtracted from the cost of your investment that you will eventually use when you sell to calculate the capital gain or loss. If you're buying a balanced ETF for a non-registered account, mind the return of capital and prepare for some record-keeping to ensure you calculate your capital gains correctly when you sell in the future.

3. Track record

Many balanced mutual funds have long histories that you can look at to check their year-to-year consistency and performance in bear markets. Most balanced ETFs are relatively new, which means you'll have to do extra research to gauge their suitability for your portfolio.

First, see whether the mix of stocks, bonds and any other assets suits your investing needs. Next, monitor the extent to which the portfolio invests outside Canada. Several balanced ETFs have a global slant that could be attractive for Canada-heavy portfolios.

Your research should also include a look at investor acceptance of an ETF, which you can gauge by looking at the day-to-day trading volumes. Be cautious with funds that go days without trading because you may not get competitive prices when buying and selling.

4. Active management

The classic stock or bond ETF is a passive fund that mirrors the returns of benchmark indexes minus fees. There's little or no active human involvement in picking securities or timing buy and sell transactions. In blending stocks and bonds, balanced ETFs automatically become an actively managed product to some extent. Setting a proportion of bonds and stocks is an active decision in running a balanced fund, and so is the choice of which countries to emphasize.

There are additional layers of active management in some balanced funds. They may feature a long list of holdings that get shuffled regularly, or use strategies that involve financial instruments called derivatives. The more actively managed a fund, the greater the complexity and risk of investing decisions that don't work out.

Balanced Funds, ETF-style

Balanced funds combining stocks and bonds are a mainstay in the mutual fund industry, but the ETF business hasn't yet built much a  presence in this category. Here is a selection of ETF balanced funds, some new and others that have been around a while.

FundTicker (TSX)Recent price ($)Assets ($million)MER (%)Distribution Yield (%)Stocks / Bonds MixOne-Year Return to Oct. 31 (%)InceptionNotes
AGFiQ MultiAsset Allocation ETFQMA-T27.172.60.55*n/aBonds: 39.2%; Stocks: 60.3n/a1/30/2017Think of QMA as an actively managed global balanced fund for conservative investors. With just 1.9 per cent of its assets in Canada, this fund has the potential to be a useful portfolio diversifier for the investor with a portfolio weighted heavily in domestic stocks and bonds. Recent trading suggests investors are taking a wait-and-see approach.
AGFiQ MultiAsset Income Allocation ETFQMY-T26.082.60.55*3Bonds: 59.2%; Stocks: 40.3n/a1/30/2017Has about 46 per cent of its assets in Canada and the rest in countries such as the United States, Japan and the United Kingdom. Lots of yield-focused holdings, including preferred shares, real estate investment trusts and dividend stocks. As with most funds in this group, the holdings are other ETFs.
BMO Monthly Income ETFZMI-T16.2998.30.614.1Bonds: 39.3%; Stocks: 60.7%6.41/28/2011Blessed simplicity here - a classic 60-40 mix of stocks and bonds, a focus on stable, dividend-paying stocks and a rough 50-50 split between Canada everywhere else. The only eyebrow-raiser is its position in emerging market bonds, but that's limited to just 2 per cent of the whole.
iShares Diversified Monthly Income ETFXTR-T11.44640.30.625.2Bonds: 52%; Stocks: 48%7.512/19/2005The juggernaut of this group, though not a huge fund by ETF industry standards. Canada accounts for about three-quarters of the portfolio, and the U.S. holdings for another 20 per cent. As for the comparatively high yield, investors with non-registered accounts should note that return of capital has accounted for a significant portion of distributions in the past couple of years.
Horizons Global Risk Parity ETF HRA-T10.2331.21.230.4Bonds: 38%; Stocks: 49%4.27/20/2016Aims for low volatility and downside risk, along with balanced fund-like returns. About 12 per cent of the fund is invested in commodities and real estate investment trusts, or REITs.
PowerShares Low Volatility Portfolio ETFPLV-T21.9739.10.582.4Bonds: 29.6%; Stocks: 70.4%8.95/6/2015Clever packaging here to focus on investor enthusiasm for low-volatility stocks. If you're looking for stock market exposure with the potential to fall less violently than the broader market in a correction, take a look. Canada accounts for about 55 per cent of the portfolio. Better one-year returns than others, but also more exposure to stocks.
Purpose Monthly Income FundPIN-T19.4832.10.745.1Bonds: 39.1%; Stocks: 33.7%5.36/9/2013The pitch here is steady, tax-efficient monthly income generated by a portfolio run with an emphasis on controlling risk. Exposure to real assets such as real estate is part of the mix, as is a hefty cash component.
Purpose Conservative Income FundPRP-T20.5160.692.6Bonds: 39.4%; Stocks: 48.5%5.226/10/2016A focus on dividend-paying and low-volatility stocks, plus bonds. Uses an options strategy to manage the downside risk of stocks. Too new for this strategy to have been battle-tested in a stock market correction. A significant chunk of the portfolio is in cash.

(source: ETF companies,

*management fee only; the fund is too new to publish a management expense ratio, which will be higher than the management fee