Over performing balanced funds set off warning bells

par Al Emid | April 18 2006 08:38PM

Although consumers certainly aren’t complaining, mutual fund experts question whether high-flying Canadian balanced funds that beat the market really qualify as true balanced funds. Specifically, the heavy weighting of some of these funds in the energy sector is cause for concern.

Originally marketed as ideal for those with limited investment dollars, limited risk tolerance or both, balanced funds contain stocks, bonds and other interest-bearing instruments, a combination that did not always produce mouth-watering returns, especially when compared to other fund categories.

Recently, however, some Canadian balanced and Canadian balanced income funds have delivered double-digit gains partially due to yields from energy equities and income trusts.

Increases in overall energy weighting, combined with the volatility of the energy sector and the rapidly increasing presence of energy-related trusts has led to some questioning about the makeup of balanced funds among some advisors.

“As an advisor if you see a fund that swings like that then you better take a look at the holdings because someone may not really have a balanced fund there,” suggests Roy Vokes, president of Vaughan-based Agora Financial Services.

No surprises

“If I’m going to pick a balanced fund, (it should have) no surprises and be dependable,” he explains. That kind of balanced fund plays its traditional role of core holding, providing stability as a hedge against volatility of other holdings.

Hoping that investors will view the situation in a similar light, Christine Hughes, senior vice-president at Toronto-based AGF Management Ltd. and manager of the AGF Canadian Balanced Fund, points out that she never joined the rush to income trusts. Referring to Canadian balanced funds in general, she says that “traditionally the equities component is geared towards income with lots of dividend paying stocks,” she explains.

“It was almost by default, not by design that weighting of energy grew in (some) balanced portfolios,” she says, adding that while energy is a cyclical investment, balanced funds typically do not hold large weightings in cyclical investments and normally specialize in safer equities such as banks and utility companies.

Higher than expected returns came at least partially through energy-related income trusts. “Now you have this different kind of product that’s slightly more risky because it’s got a heavy weight in ‘cyclicals’ whereas it never used to,” she says, attributing that to the heavy proportion of energy trusts in new income products issued over the past five years.

Historically, equity holdings in these funds components have been dominated by dividend paying stocks. This has included financials like the banks, the pipelines and utility groups.

Recently, some balanced funds invested in energy trusts, not specifically for exposure to the energy sector but to receive the greater yield of trusts. The net result was a higher-than-normal weighting in the energy sector, she suggests.

Ms. Hughes hopes that the Canadian balanced fund pendulum will swing back to something closer to the original mandate of balanced funds.

Her portfolio does hold energy-related equities but does not hold income trusts. At Feb. 28, 2006, Canadian bonds accounted for approximately 29% while financial equities accounted for roughly 20%, making them the two largest categories in comparison with energy holdings at 14%. This approach means that the fund is not subject to potential drops in income from energy-related trusts.

Reducing risk

Attempting to reduce risk by combining the best of several worlds, some fund companies market fund-on-fund balanced portfolios. “What they’re trying to do is get a packaged good that uses balanced funds,” Mr. Vokes says.

Some portfolios indirectly replace both balanced funds and asset allocation funds, he explains. “Perhaps you’ve got a fund on fund portfolio that includes a Canadian equities fund, bond fund, and money market fund (investments that, taken together could very well comprise a balanced fund),” he says.

Some potential drawbacks in these portfolios may leave the advisor still preferring traditional balanced funds, Mr. Vokes says. For example the portfolio may contain a fund that the advisor feels is unsuitable or has a manager whose expertise is still unproven, he says, adding that he hesitates to use one company’s portfolio for those reasons.

Toronto-based Franklin Templeton Investments Corp. has two Quotential portfolios (out of seven in total) that amount to a ‘super-balanced’ fund-on funds both with a majority of holdings within Canada, according to Elizabeth Lunney, vice-president and portfolio manager for its Private Client Group.

The Quotential Balanced Income portfolio normally has a benchmark of 60% income-producing assets and 40% equity assets while the Quotential Balanced Growth normally has a benchmark has 60% equity assets and 40% income-producing assets. Both contain a basket of conservatively-managed funds.

Franklin Templeton styles the portfolios as a one-stop shop balanced solution, combining growth and capital appreciation, according to Ms. Lunney.


The energy sector’s inherent volatility has already led to some changes within the funds, Ms. Lunney explains. “Through 2004 and 2005 we had a maximum Canadian equity overweight. We were quite bullish on the Canadian market for a variety of reasons (including) relative valuations compared to the United States and global markets and also seeing opportunities for the materials and energy sectors.”

However in July 2005, increased valuations in the Canadian energy sector led to the decision to reduce Canadian equities and increase holdings in other countries.