A balanced fund often promises a one-stop shop by investing in a mix of stocks and bonds, and even ultra-safe investments like money market securities. The key is balance -- a balanced mutual fund doesn't swing for the fences for performance, seeking to provide a return that, over time, blends the returns of stocks and bonds.
An investment in the prototypical balanced fund in 1926 would have generated annualized returns of 7.8% through 2015, before fees, but your true total return will likely be much smaller than historical experience for one very big reason. Here's all you need to know about this category of mutual fund.
What a balanced fund invests in
A balanced fund typically holds about 50% to 70% of its assets in stocks, with the remainder made up of bonds and cash-like investments. There is no universal definition, as funds differ dramatically between managers.
Case in point: The Vanguard Balanced Index Fund held about 59% of its assets in stocks, and about 40% of its assets in bonds and other fixed income products. The remaining 1% was held in cash.
Alternatively, the American Funds American Balanced Fund held 56% of its assets in stock, and about 33% of its assets in bonds. The remainder -- more than 10% of the fund's assets -- was "invested" in cash and cash equivalents.
These two funds that purport to offer similar strategies, but how they achieve balance is very different. And despite the name advertising balance, neither fund holds a substantial percentage of foreign stocks.
Advantages and disadvantages of balanced funds
The main draw of a balanced fund is convenience. Instead of buying a collection of funds, you can theoretically achieve diversification by investing in just one balanced fund. Likewise, you can put your full faith in a single asset manager to pick the best investments across all investment types, from stocks to bonds, and occasionally, even commodities. (Depending on your perspective, a go-anywhere mandate for a mutual fund manager may or may not be a benefit as much as a potential problem.)
The disadvantages to balanced funds are numerous, and some disadvantages have become particularly pronounced since the Great Financial Crisis caused a decline in interest rates.
Investors should note that balanced funds typically charge stock fund-like fees, despite the fact that bonds can make up 40% or more of their assets. This is a huge disadvantage when one considers that actively managed bond funds typically charge lower fees than actively managed stock funds, due in part to the lower expected returns of bond investing.
Returns can also be dragged down by large cash allocations, which typically supplant bond investments in a portfolio. Not only does cash produce zero return, but it actually costs you money as the fund manager will charge you a management fee on the cash it keeps in its portfolio for you. (If you wouldn't put your savings in a bank that offered negative 1.5% interest each year, then you shouldn't put your wealth in a fund that charges you a management fee of 1.5% to keep some of your assets in cash, either.)
Some drawbacks are less concerning. Take into consideration that fund managers typically have leeway to change their allocations between stocks and bonds as they see fit -- buying more stock or bonds when one appears to be a better investment relative to the other. For investors who prefer to manage their own stock and bond allocation, a balanced fund is probably not a good fit, as the stock and bond allocation may change dramatically, negating their appeal to "hands-off" investors.
Finally, balanced funds are not created equally. As no two balanced funds are the same, one cannot simply compare funds on the basis of their name. Whereas you know exactly what you're getting with an S&P 500 Index fund, the same is not true of a balanced fund. Though they are pitched for convenience, the truth is that a balanced fund requires just as much, if not more, due diligence than any other index fund or mutual fund.
An alternative to a balanced fund
Creating your own low-cost balanced portfolio can be as easy as investing in two stock funds, and two bond funds, for a total portfolio of just four index funds:
- Total U.S. stock index fund
- Total International stock index fund
- Aggregate U.S. bond market index fund
- Aggregate International bond market index fund
With funds built around these four common themes, you can own every stock and bond of worthwhile size on the global stock market, acheiving diversification and balance at a low price. Index funds that track the total stock and bond markets cost as little as 0.05% annually, a mere fraction of actively managed balanced products.
But if you have any doubts, consider this: Over history, a blend of 60% stocks and 40% bonds has produced an annual return of about 7.8%. Investors who pay as much as 1.5% in fees each year to own a balanced fund thus surrender about 20% of their total returns to their mutual fund company and financial advisor. These fees are all the more menacing when one considers that balanced funds are designed to produce relatively benign investment returns.
Muted returns and above-average fees are a very high price to pay for convenience.
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