A Balanced Perspective On Balanced Funds

“Now don’t be sad, ‘Cause two out of three ain’t bad”

While Meatloaf sang “Now don’t be sad, ‘cause two Out Of Three Ain’t Bad” on the “Bat Out of Hell” album, looking at the performance of balanced fund managers will have you singing from a different song sheet. What ain’t bad is that over the last ten years about two out of three actively managed balanced funds outperformed the benchmark index. What is bad is that when you factor in their fees outperforming funds drop to one out of three, and worse for shorter time periods, if held in a RRSP or RRIF.

Looking Through Rose Coloured Glasses

Each quarter RBC Investor & Treasury Services’ Pooled Fund Survey compiles the pre-fee returns of over 90 asset managers (primarily Canadian) covering 700 high quality funds that are available to Canadian institutional investors. The survey shows the results for balanced funds as well as those for Canadian and foreign equities and bonds. Returns are shown pre-fees to highlight the gross returns that are generated and to make an apple to apples comparison as the funds have different fees.

I focused on balanced funds as they represent the average Canadian’s investment portfolio. Balanced funds typically own 40% in fixed income securities and 60% in stocks. The institutional benchmark I have used for performance comparison has a 2% weight in the FTSE Canada 91 Day T-Bill Index, as that is the typical amount of cash in an institutional investment fund. The other 38% of the fixed income weight is in the FTSE Canada Universe Bond Index.

For stocks, I applied the typical split used by Canadian investment managers. For North America, that is 30% in the S&P/TSX Composite Index and 15% in the S&P 500 Index. The remaining 15% weight for foreign stocks is in the MSCI ACWI ex U.S. IMI Index. This abbreviation-heavy index, in plain English, is the Morgan Stanley Capital International All Country World Index ex United States Investable Market Index. Quite a mouthful, but the best index to measure all the large, mid and small cap stocks in developed and emerging countries, covering stocks worth $23 trillion USD.

Chart 1 below compares the Balanced Funds Median pre-fee performance (half of funds do better, half worse) versus the weighted performance benchmark. Given the time lag for gathering numbers from all the fund managers, the latest data is for the quarter ended March 2020. This is the rose coloured glasses version as no fees are deducted from the returns. Mitigating this advantage somewhat, the comparison is to the institutional benchmark, which does not incorporate any fees or trading costs.

Chart 1

Source: RBC Investor & Treasury Services, Wayfairer Capital Management

What you see is that over the last ten years the Balanced Funds Median outperformed the benchmark by 0.37% (6.29% vs 5.92%). Hats off and job well done to the investment managers! Overall, two out of three ain’t bad as 64% of funds outperformed the benchmark. The results were less impressive over 5 years with a return difference of only 0.12% and 56% of funds outperforming. The last three years have been tougher with the Balanced Funds Median slightly less than the benchmark and only 49% of funds outperforming. But is this the right way of looking at performance for individual investors?

Looking Through Corrective Lenses

You can’t eat pre-fee performance. What matters to individual investors is after-fee returns. I reduced the fund returns from the RBC survey by 1%, which is the typical fee for investing $1M of combined family assets. I have also done the analysis based on holding a fund in a RRSP or RRIF, so the fees are not tax deductible.

Another critical change is the benchmark. Instead of using market indices, I created a realistic, investable, low cost and tax efficient portfolio of ETF’s.[1] . The ETF’s are passive funds that are designed to deliver the performance of their market benchmark, less their low management fees and other expenses. The overall fee for this portfolio is an incredibly low 0.07%. You can already see the challenge here: active balanced fund managers must outperform this benchmark by 0.93% just to breakeven with it! Chart 2 shows us how the Balanced Funds Median has fared against this ETF portfolio.

Chart 2

Source: RBC Investor & Treasury Services, Wayfairer Capital Management, BlackRock, Vanguard

What a different story! The Balanced Funds Median return over the last 10 years was an annualized 5.29%, 0.46% less than the ETF portfolio.  It was also lower than the ETF portfolio over the last three years and five years. Over the last 10 years, two out of three was bad as that is how many actively managed funds underperformed the ETF portfolio. It gets worse as the time periods shorten. Over the last 3 years and 5 years about 80% of funds underperformed the ETF portfolio.

Looking Through A Magnifying Glass

In Chart 3 below I take an even closer look at the after-fee returns versus the ETF portfolio for investments in an RRSP or RRIF. The chart shows the difference in returns between the funds and the ETF portfolio by quartiles. The first quartile data show that over the last ten years the top 25% of funds outperformed the ETF portfolio by an annualized 0.15% or more. That’s the good news. The bad news is that the bottom 25% of funds underperformed by 1.03% or more. And the results get worse for the shorter time periods.

Chart 3

Source: RBC Investor & Treasury Services, Wayfairer Capital Management, BlackRock, Vanguard

Looking Through CRA’s Eyes

The results improve significantly if you can deduct your management fees for investment funds held in a taxable account and claim credits for any U.S. and foreign withholding taxes. As Chart 4 shows, on an after-fee basis the returns for the Balanced Funds quartiles all improve by the amount of the tax savings, or about 0.53% assuming a 45% marginal tax rate. The first quartile funds now outperform over all three time periods. The Balanced Funds Median only slightly outperforms over 10 years and still underperforms over three and five years. The bottom 25% of funds underperformed significantly in all time periods. Overall, 51% of Balanced Funds outperformed the ETF portfolio over 10 years, and about 37% over 5 years and 3 years.

Chart 4

Source: RBC Investor & Treasury Services, Wayfairer Capital Management, BlackRock, Vanguard

20/20 Vision

Competitive investment products are an integral part of the services provided by traditional advisory firms and online platforms. Be careful when utilizing actively managed funds as over the last ten years about two out of three actively managed balanced funds have underperformed a low-cost portfolio of ETFs in an RRSP/RRIF, with that ratio improving to about one out of two if the funds are held in a taxable account. Fees really make the difference. History tells us that if you pay more than 1% in fees after tax, it will be extremely difficult to outperform the ETF portfolio.

When you have your investments managed by an advisor or through an online platform it is critical to get value for your fees. However, value is not just about the returns you earn. Great advisors and online platforms provide wealth planning, expertise to choose risk appropriate investments, and monitoring and rebalancing of your portfolio. They factor in any social and ethical considerations you have. They earn your trust through regular communication and transparency on performance and fees as they work to achieve your financial goals.

Despite the performance challenge for actively managed balanced funds over the last ten years, there is still a role for focused active management in many portfolios. In future blogs I will look at where actively managed funds are more likely to outperform ETFs. I will also provide guidance on what to look for in a good active manager to increase the odds of selecting one who can produce top quartile investment returns.

[1] The ETF portfolio has 2% invested in Canada 91-day T-bills, 38% in the iShares Core Canadian Bond Universe Index ETF, 30% in the iShares Core S&P/TSX Capped Composite Index ETF, 15% in the Vanguard S&P 500 Index ETF and 15% in the Vanguard FTSE All-Word ex-US ETF.