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Portfolio Strategy

Huddling for safety in balanced funds comes with a price Add to ...

There has never been a worse time to own balanced funds, and yet nothing is more popular in the mutual fund world right now.

Oh, those thickheaded investors? No way. Balanced funds make sense for nervous types, even if they too often demonstrate the fund industry at its most exploitative.

Here's a new rule for the uncertainty of 2010: Sometimes, less than optimal investing solutions are better than letting your emotions guide you.

Has your gut been telling you to stay out of stocks and keep your money safe in high-interest accounts, money market funds and bond funds until conditions look more stable? If you listened, then you've missed a 50-per-cent gain in the stock market since it bottomed in March, 2009.

True, the markets have essentially gone nowhere since last winter and may have some room to fall. But if you've been out of the stock market for the past 18 months or so, you missed a rally that repaired a lot of the losses in the big market crash.

That wouldn't have happened if you owned a balanced fund. Depending on the exact type, balanced funds may hold between 25 per cent and 70 per cent of their assets in bonds and the rest in stocks and cash. You are automatically investing in a diversified portfolio, in other words. You may not want to venture into the stock market by investing in an equity fund, exchange-traded fund or stocks, but balanced fund managers are doing just that with your money behind the scenes.

And what if the stock market falls? With their heavy bond holdings, balanced funds decline less than pure investments in stocks. That means nervous investors are more likely to stick with them over time and not sell prematurely.


"People are just more patient with balanced funds, generally," said Dan Hallett, director of asset management for HighView Financial Group. "Their losses technically are the same [as if they owned separate bond and equity funds] but they don't see their stocks fall by half. They see the whole thing fall by 25 per cent."

The benefit of combining stocks and bonds together into a livable mix is the most often mentioned explanation for the way in which balanced funds dominate the fund world today. The 12 months ended July 31 were typical of the high level of interest in balanced funds since the bear market of 2008-09 - balanced funds of all types posted total net new sales of $16.2-billion, according to the fund analysis firm Credo Consulting. Bond funds had net new sales of $11.2-billion, to take second place, while all equity categories had either net selling or negligible gains.

"Bear markets always trigger more interest in balanced funds," Mr. Hallett said. "I saw this in 2001-02, and it's not surprising that it's happened again."

If you're a long-term investor who needs a decent rate of return to achieve your goals, then investing in a balanced fund instead of a money market fund or even a bond fund is the better play right now.

But let's not get too cozy with balanced funds because a lot of them are machines designed to extract egregiously high fees from conservative, less-than-savvy investors. With interest rates as low as they are today, the matter of fees has never been more important.

If rates are depressed, then the same can be said of returns from the bond portion of a balanced fund. Let's use the DEX Universe Bond Index as a proxy for the entire bond market in Canada - its yield late this week was about 2.8 per cent.

A balanced fund might easily have fees that chop as much as 2.3 percentage points or more off its returns (returns are published on an after-fee basis). So now you're looking at a gain of something like 0.5 per cent from the bond portfolio of a balanced fund.

Bonds have actually been rising in price lately, which means there's potential for balanced funds to report gains on bonds that are worth more than the purchase price. That could help pump up balanced fund returns a bit in the near term.

Eventually, though, the economy will enter a strong, sustained growth phase and interest rates will rise. The capital gains that bond funds are seeing now will turn into capital losses then, and that in turn will hurt returns from bond funds.

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