Benefits and Challenges of Balanced Investing

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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Michael Keaveney, VP, Managed Solutions, CIBC Asset Management.  

Balanced products that invest in both the stock market and the bond market do have negative periods from time to time. But the implicit appeal of the balanced approach is that the bonds are expected to provide the ballast to mitigate overall downside in periods where equity markets are suffering. And certainly that was true in the global financial crisis around 2008. Equity markets back then suffered terribly, but bond markets were positive. So the overall experience, while quite negative, could at least support the wisdom of a diversification benefit of a balanced approach.  

But 2022 was different. Bonds faltered in a historic way at the same time stocks were down.  

Central banks around the world went on a very steep rate hiking cycle to rein in a spike in inflation. And as a result, bonds plummeted and didn’t provide any real diversification support for the declining equity markets. And a relatively commonplace stock market drop was fully felt and sometimes more than fully felt in balanced portfolios. So it’s not a stretch to say that some balanced investors might not have been prepared for that and started looking at other options.  

Those same rate hikes that sent bond markets reeling were very positive for vehicles like GICs and high interest rate savings accounts. And all of a sudden, these investments were quoting relatively high yields in an environment where other vehicles were stumbling pretty badly. I suspect a number of investors who were in balanced portfolios because they had identified as long-term investors with long-term goals, made the switch during and after 2022 to thinking of safety first and short-term considerations.  

But balanced investors have had a favourable environment over the course of 2023 and so far this year when the bounceback in equity markets and the end of that rate hike cycle for most central banks have combined to produce very attractive returns for a diversified investor, eclipsing in many cases the safe returns of the GIC. And now we’re at a point where several central banks have entered into a rate cutting cycle, including the Bank of Canada, which has now cut in two consecutive meetings starting in June and continuing in July.  

Other key central banks such as the U.S. Fed had not started cutting as early but are starting to signal that cuts could be on the horizon. And this could be favourable for investing in general and for the bond component of balanced portfolios, in particular.  

With the rate hikes of previous years, the income in fixed income is back, and yields are already attractive in many places. And as policy rates could drop, there might be potential additional gains available.  

So while it’s actually been a favourable environment for balanced investors for quite a while post 2022, not everyone has got the message.

So perhaps a rate cutting cycle which we seem to be in the midst of now will reduce the appeal of new GIC investments and allow the considerable recent success of balanced investing to continue. 

So, there are tax differences in these various opportunities for investors and if somebody is investing within a non-registered account, then the tax status of the gains one receives could be a consideration. In those types of accounts, when using a GIC or a high interest rate savings account even, the earnings will likely take the form of interest income, and that doesn’t receive a tax break from the government and will be fully taxable at the investors marginal tax rate.  

On the other hand, when a balanced portfolio has gains in a taxable account, there’s likely to be more diversity in the nature of the gains. There could be some interest income, but there could also be capital gains and eligible dividends. Capital gains and eligible dividends have favourable tax treatment compared to interest income. So, a balanced portfolio will probably have a mixture of tax treatments resulting in a lower overall blended tax rate than pure interest income in non-registered accounts.  

Taking a balanced investment approach is not without a number of challenges. First, there are two behavioural considerations, which are mainly just flip sides of the same coin of being susceptible to unhelpful comparisons. Having a balanced approach will almost certainly mean that your returns over any particular period will lag the flavour of the moment investment or, put another way, the best-performing asset class. Now, maybe your balanced approach has some of that investment. But it might not be enough to satisfy that nagging feeling that you could have done better if you had just focused more on that great performer.  

Balanced Investors rarely step onto the podium to collect the top performance award, unless they’re being compared only to other balanced investors. So there could be a bit of FOMO as the kids say, or fear of missing out, baked in to the balanced approach. On a related note, if diversification is doing its job, there will almost always be something in a balanced portfolio that isn’t doing well. After all, diversification means not putting all your eggs in the same basket in an uncertain world, and wanting exposure to different return patterns because the short term is unpredictable.  

So something’s always going to be at the bottom of the list of returns in a balanced portfolio, and the temptation might be to get rid of the supposed underperformer, which isn’t always the right thing to do.

Now, while fear of missing out and regretting your diversification are potential challenges, the good news is that these challenges are really about behavioural self regulation. We’re all human, and may never be completely free of fear and regret, but the best antidote to these is to have an investment plan with clear goals and objectives. That can go a long way to reduce the shiny objects of FOMO and regret, and speaks to one of the great potential values of receiving sound advice, which is the benefit of ongoing behavioural coaching.  

Another challenge is that it’s hard for any one person whether it’s an individual, a single advisor, or even a single investment manager to be expert in the multitude of asset classes, and sub asset classes that conceivably form part of a balanced portfolio. In an increasingly complex world, there are more and more investment opportunities that have become available to investors. Opportunities, for example, in private markets, alternative investments, etc. That requires not only an expanding level of expertise at the asset class level, but speaks to the increasing importance of the role of putting all these things together in a coherent way. The asset allocation and portfolio construction work.  

For balanced investors, asset classes are like the potential ingredients in a recipe: you can have the freshest ingredients in the world, but how you put them together matters. And it’s possible to combine them in a way where the meal doesn’t turn out so well. So, being a successful balanced investor requires an additional set of skills a bit like those of the gourmet chef over and above the virtues of the underlying ingredients.  

There are more benefits of a balanced approach, but I want to focus on one in particular, and that’s a balanced approach that takes the form of some sort of packaged solution. We know that there can be a difference between the returns that an investment vehicle delivers and the returns the underlying investor receives.  

Global investment research company Morningstar has been examining the difference in the returns investment vehicles deliver and the returns the investors actually get for a number of years. They measure what they call the behaviour gap. And that’s the difference in the time weighted, or the investment returns, and the money weighted, or the investor returns, to retail investment products over time. Their most recent study published covered the 10-year period to the end of 2022. Now, that study uses U.S. data and categories, but we believe the same phenomenon is applicable here. It’s certainly common to have situations where fortunate timing of cash flows results in higher investor returns than returns to an underlying investment. But over long periods, when looking at the overall results in two broad categories, two patterns are clear. First, across categories investors on average underperform the investment vehicles they choose. This study has been repeated by Morningstar several times, and while the numbers change from year to year, the direction doesn’t. Investors on mass underperform their investments. But second, and most important for this discussion, the gap is narrower for balanced funds versus other categories.  

Now Morningstar pointed to a link between more negative investor gaps and more volatile categories. But balanced funds also fared better than the less volatile fixed-income asset class. So what is it about balanced funds? 

After all, balanced funds are actually just investing in the same asset classes as these other categories. But the gap is lower than a combination of the other categories individually.

We think a lot of the explanation resides in the fact that the balanced wrapper shields the investor from noticing individual asset classes that have underperformed the others over short periods, and they’re more likely to stay invested in the whole solution.  

So balanced funds can be a very effective tool in supporting positive investor behaviour and helping to narrow the behaviour gap. In this way, this is a product-driven supporting tool for a couple of the challenges I mentioned earlier, around fear and missing out. To the degree that a package solution of the balanced investing approach focuses on the overall results and away from the individual components, it can help an advisor keep an investor focused on the big picture and less on the distractions.  

So who are these types of solutions best suited for?  

Well, balanced solutions actually cover a lot of ground. In the Canadian retail investing space, for example, the multiple product categories that contain various balanced funds range from around 20% equity exposure at the lower end of the fixed-income balanced categories all the way up to around 90% equity exposure at the upper end of the equity balanced categories. These are all categories popular with investors, so the appeal is broad. And what the right balance is, is in the eye of the beholder, hopefully with the benefit of sound advice.  

Depending on the underlying construction of the portfolios, which includes but isn’t limited to the equity mix, some balanced solutions are best suited to Investors at the wealth accumulation stage of their journey, and others work best as regular distribution generators, more income oriented, delivering that at least in part from a focus on higher income generation from the underlying securities.  

But generally balanced solutions are best suited for investors with reasonably long time horizons and at least a low to medium or medium tolerance for risk. Now, with those factors in mind, and the multitude of possibilities, most investors are likely to be well served by a balanced solution for at least some portion of their investment goals.