There’s a balanced ETF for investors who think the 60-40 portfolio mix is dead

Balanced ETFs are the great problem-solver for people seeking a smart, simple way to invest – except for one small problem.

Consensus on what a balanced portfolio actually looks like has broken down as a result of the plunge in bond yields during the pandemic. Since they were introduced in early 2018, almost all balanced exchange-traded funds have defined balance as a 60/40 mix of stocks and bonds.

“I’m going to call this the old-school way,” said Steven Hawkins, chief executive and chief investment officer at Horizons ETF Management. “We think that a balanced portfolio with a 70/30 asset mix, at least as a target, is the newer-school way of looking at a balanced portfolio of stocks and bonds.”

Your checklist when comparing ETFs should include cost, the reputation of the ETF company, the soundness of the indexes or investing strategies it uses and popularity with other investors. In the balanced ETF category, you also need to look at the mix of stocks and bonds. Do you want the proven diversification of a traditional 60/40 mix, or something more aggressive to offset today’s painfully low bond yields?

Balanced ETFs, also known as asset allocation ETFs, are a popular product that bundles all the elements of a diversified portfolio into a single fund you buy like a stock through an online broker or trading app. These ETFs instantly solve the problem of what to put in a portfolio that scores well on fundamentals such as low cost, broad diversification and simplicity. Just keep shovelling money into your balanced ETF.

Within the balanced fund ETF category are funds designed for conservative investors (mostly bonds) and growth investors (mostly or even entirely stocks). In the sweet spot between these two products lies the 60/40 balanced fund. Yes, it’s a bit confusing – balanced funds are a sub-category of balanced ETFs.

The balanced fund option is ideal for someone who is investing for 10 or more years and wants to temper an emphasis on stocks with significant exposure to bonds. But while a 40-per-cent bond weighting seemed right for balanced investors as recently as the start of 2020, it’s now being questioned.

One reason is that bond yields, notably those safe government bonds, are depressed to the point where a 10-year Government of Canada bond offers all of 0.5 per cent. Unless bond prices fall further – lower rates would send bond prices higher – you’re looking at basically dead money if you own bonds or bond funds.

Looking ahead, some market strategists and economists see a risk that inflationary forces will build and cause bonds to fall in price. If that happens, investors will find that the bonds they bought for stability end up hurting their returns.

Many investors minimized their bond exposure long ago because of low yields and got an education about how bonds can stabilize a sinking portfolio when stocks crashed in March. The latest debate about bonds is not whether you need them at all, but rather how much exposure is ideal.

The Big Three ETF companies in Canada, BlackRock, BMO and Vanguard, each had a stocks-bonds mix of more or less 60/40 for their balanced ETFs at the end of July. Horizons was the outlier with a 70/30 blend.

The debate over which asset mix is best will be settled only after we reach a postpandemic level of normalcy and a few years have gone by. Insubstantial as they are, the short-term results of the past 12 months favour the 70/30 mix.

The Horizons Balanced TRI ETF Portfolio (HBAL) made 8.3 per cent over the 12 months to June 30, compared with between 4.7 per cent and 5.5 per cent for the competition in the balanced fund category of balanced ETFs. By a hair, HBAL was also the best performer of the group for the past six months.

The U.S. investing giant Vanguard introduced asset allocation ETFs to Canada in January, 2018, and has run since the beginning with a 60/40 mix for its balanced fund option, the Vanguard Balanced ETF Portfolio (VBAL).

“Whether it’s 60/40 or 65/35, the simple balanced portfolio has been going for almost 100 years now – since 1929 – and has dealt well with crises through that,” said Scott Johnston, Vanguard’s head of product in Canada.

As for the argument that the same old bond weighting in a balanced fund will hurt returns, Mr. Johnston said Vanguard now projects annualized gross returns of 4.1 per cent from a 60/40 portfolio held by Canadian investors over the 10 years ahead, up from 3.8 per cent at the end of last year. The extra push comes from stocks offsetting low bond yields thanks to the better valuations that emerged after the March crash.

The asset mix for HBAL has been at 70/30 since the fund was introduced two years ago. By the way, the “TRI” in the name stands for total return index, a term that refers to the fact that the price of the ETF units rises and falls by a total return of share price plus dividends, and that no dividends are paid as cash.

Adding an extra 10 percentage points of stock exposure to a portfolio like the one in HBAL seems simple enough, but there’s actually a big question to contend with. Exactly where does that extra 10 per cent go?

For HBAL, Horizons decided to add exposure to the tech-dominated Nasdaq-100 Index as a complement to the usual holding of large U.S. stocks (which itself has significant tech exposure). The Nasdaq weighting, pegged at 17 per cent as of late July, is a huge reason for the fund’s outperformance this year.

By contrast, the BMO, BlackRock and Vanguard balanced ETFs all use a single broad-based index for U.S. exposure. These indexes typically have about 25 per cent of their assets in tech stocks such as Microsoft Corp., Apple Inc., Amazon.com Inc., Alphabet Inc. and Facebook Inc.

HBAL will underperform if tech hits a wall, but Mr. Hawkins plays down this risk. “In this day and age, especially given where we are in the COVID cycle of business, some of the best performing products out there are technology-focused,” he said. “You’ve got Amazon, Zoom, electric cars. That type of new school company is, from our perspective, a way of the future. And I don’t believe that’s going to change.”

Horizons has also bumped up the stock market exposure of its conservative balanced ETF, the Horizons Conservative TRI ETF Portfolio (HCON). It holds a 50/50 split, while competitors are in the area of 40-per-cent stocks and 60-per-cent bonds. HCON had a 12-per-cent weighting in the Nasdaq-100 at the end of July, a key reason why the fund has beaten its peers in the short term.

This Nasdaq exposure is a reminder that moving to a 70/30 mix from 60/40 means more risk. That’s unavoidable when you reach for higher returns with an extra helping of stocks.

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