Will Your Balanced Fund Protect You In The Next Bear Market?

Balanced FundI recently attended a luncheon at which a balanced fund manager for a well-known financial services provider spoke.  He shared several thoughts about the current investing environment and also touted his fund’s performance during the 2007 to 2009 equities bear market.  As the fund manager was discussing his fund’s outperformance of the S&P 500 during the most recent bear market, I began to wonder whether his or other balanced funds will be able to repeat the outperformance during the next bear market in equities.



What is a balanced fund?

A balanced fund is a pool of money that is invested in multiple asset classes.  The typical balanced fund invests in stocks and bonds, keeping only a small portion of the assets in “cash.”  During equity bear markets, many investors would expect balanced funds to outperform equity funds as the bond portion of the portfolio smoothes out returns.  It doesn’t always happen that way, but the balance across asset classes is still quite attractive to many investors.

One example of such a fund is the Vanguard Balanced Index Fund Investor Shares (VBINX), which as of 10/31/2012 was allocated 59.59% to stocks and 40.19% to bonds.  This $17 billion fund did outperform the S&P 500 during the most recent equity bear market, although its nearly 40% peak-to-trough decline was nothing to get excited about.


Will balanced funds outperform during the next bear market?

I think balanced funds, as a collective group, are likely to outperform once again during the next bear market in equities, but I anticipate that outperformance to be less than many investors expect.  Here is why:

Most balanced funds keep short-to-moderate durations on the bond side of their portfolios.  VBINX, for example, currently sports an average duration of 5.1 years.  In a typical cycle in which the Fed raises interest rates before a bear market commences, investors could expect short-to-moderate durations to provide enough upside in their portfolios to drive solid outperformance.  But this isn’t your typical cycle.  I think the chances are quite good that the next bear market in equities arrives before the Fed is able to complete a series of interest rate hikes.  And if that happens, given where short-to-moderate-term bond yields are currently trading, it will be difficult for balanced funds to squeeze any significant juice out of the bond part of the portfolio.

If a balanced fund holds Treasuries in the sub-7 years to maturity space, there isn’t a whole lot of room for notable price appreciation, even if yields decline during the next bear market in equities (which they likely will). Also, given that cyclical bear markets in stocks typically occur over shorter periods of time (stocks take the stairs up and the elevator down), there is likely not going to be enough time for the balanced funds to benefit from riding the yield curve in Treasuries.

Regarding corporate bonds, spreads typically widen during bear markets in so-called “risk assets.”  That puts downward pressure on the price of corporate bonds.  But when the Fed has room to lower interest rates, and benchmark Treasury prices rally, this can help to offset some, if not all, of the spread widening in corporates (depending on the credit quality of the underlying company and the severity of the economic contraction).  If yields, however, don’t head much higher than they are today before the next bear market in “risk assets,” then balanced funds will struggle to realize the same type of performance they typically do from the corporate bond part of their portfolios.

I think the Fed’s failing to complete a tightening cycle prior to the next equity bear market could have longer-lasting consequences for financial markets that investors have yet to fully appreciate.  One of those consequences will be the underperformance of balanced funds relative to investor expectations.

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