Maximising outcomes with a balanced fund

We believe there is a role for balanced funds in many portfolios, but not all balanced funds are created equal.

Traditionally balanced funds have applied a pretty restrictive mandate, usually with around 60% of their fund portfolios invested in growth assets and around 40% invested in income-producing assets, with the aim of providing diversification for investors.

We believe having more flexibility and a broad range of tools available to a fund manager can enable them to make performance-driven decisions and assist them in managing risk. In our view, there are five key elements that are essential to managing a successful balanced fund:

1. Flexibility to drive returns

   If you believe an active fund manager has the skill to outperform, you should give that manager the flexibility and opportunities to make active investment decisions. A balanced fund with a rigid 60/40 split between growth and income assets will be limited in its asset allocation. Managers will likely be restricted in the types of assets they are allowed to hold or have geographic limitations.

   This inflexibility prevents the manager from taking advantage when they see relative value on offer across asset classes, leaving little room to capitalise on opportunities that may arise. We believe having the flexibility to invest across different asset classes, and at a security level within those asset classes, is key to maximising investor returns. Capital needs to flow to the most attractive opportunities, whether that’s in domestic or global equities, domestic or global government bonds or corporate bonds.

2. Building a portfolio from the bottom up with individual securities

   There are two primary ways to construct a diversified portfolio – own securities directly, or use a building block approach that invests in managed funds and ETFs. Most diversified portfolios take the latter approach and therefore outsource equity and bond research to different companies.

   Building a portfolio from the bottom up, using individual securities, enables the manager to analyse the entire capital structure of a business and decide which securities are most attractive: eg equities, bonds or hybrid offerings. It also means every security is constantly fighting all others for capital, and every security is bought with the expectation it will be an active contributor to fund returns. A bottom-up approach does, however, require deep expertise from the manager and a well-resourced team.

3. Using derivatives to manage portfolio risk

   Maximising returns is top of the list for many investors, but managing risk is often a close second.

   Depending on the parameters the manager is bound by, derivatives can carry increased risk, but they can also be used to manage risk in a portfolio. If you are unfamiliar with derivatives, they are simply a trading tool whose price is dependent on the price of the underlying asset(s) it tracks. If you’ve ever seen the 1980s movie Trading Places, Eddie Murphy and Dan Ackroyd use a type of derivative – frozen concentrated orange juice futures – to get rich and outwit the movie’s antagonists, the Dukes (Editor’s note – warning – Trading Places has not aged that well, it would probably be considered rather un-PC these days…).

   Derivatives are not solely used with the aim of making a profit, however, as they are also a useful tool to manage risk at a portfolio level, without having to always buy and sell underlying portfolio holdings to adjust exposures. For example, say a fund manager likes the prospects for a US-listed stock but thinks that the US market as a whole is overvalued, they can buy the individual stock then use futures to reduce their exposure to that market as a whole. This hedging allows the manager to control overall exposure to equities without having to reduce positions in attractive individual companies in these regions. The manager can aim to reduce portfolio risk, without necessarily diluting returns.

4. Active currency management, to enhance returns

   This is an extension of our point about derivatives, but worthy of mention in its own right; currency allocations can be actively managed using derivative overlays.

   By divorcing equity research from currency research, a fund manager can seek out attractive investment opportunities in countries where the manager believes the currency is overvalued.

5. True alignment of interests between the portfolio manager and the end investor

   When the interests of investment managers and their clients are aligned, it creates a shared objective of maximising returns. To ensure that managers continually strive to outperform for their clients, we believe the right incentive structures need to be in place.

   Measures such as employee ownership of the firm, co-investment in the fund, and performance fees all help to ensure interests are aligned. Performance fees are a great incentive to strive for outperformance, which is good for the client and for the business. A fair fee structure is essential though, ideally with a low base fee and a high-water mark that ensures the manager isn’t paid to recover past underperformance.

If you’ve read this far, you won’t be surprised to learn that this is exactly how we manage the Allan Gray Australia Balanced Fund. It’s a diversified managed fund with the flexibility to drive long-term returns. The Fund invests in equities, fixed income instruments, cash and commodity-linked instruments and can use derivatives within the investment restrictions set out. We can vary the Fund’s exposure to different asset classes depending on where we find value, the potential for capital growth and income, and risk of loss. While the Fund has no industrial or market sector investment targets, it is anticipated the Fund will hold:

• 40 – 90% of its net asset value (NAV) in equities
• 10 – 50% of its NAV in fixed income instruments (including bonds, notes and money market instruments) and cash
• 0 – 10% of its NAV in commodity-linked instruments.

The portfolio may move outside these ranges from time to time, in pursuit of the Fund’s investment objectives. Generally, around 60% of the Fund’s portfolio is expected to be invested in Australian assets, with the remainder in international assets, however there are no geographical targets.

All multi-asset funds that invest across various geographies and asset classes do, of course, carry risks and our Balanced Fund is no exception. These can include things such as market and individual investment risks, geographic risks, derivative risk, credit risk and currency risk. More risk information is available in the Fund’s disclosure documents.

If you are looking for fund that seeks to be flexible to take advantage of what we perceive to be the best market opportunities regardless of geographic location or asset class, please visit our Fund page to learn more.

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