Systematic Relative Strength

A balanced fund is a fund that is designed to balance income, growth, and capital preservation. Balanced funds have some special attributes, a couple of which are summarized in this article in the Baltimore Sun.

1) The SEC requires that any fund purporting to be balanced maintain at least 25 percent of its assets in fixed-income senior securities — that is, debt securities, such as bonds and notes, and preferred stocks.

2) A balanced fund is designed to be a complete investment program. As the prospectus for American Balanced Fund puts it, “The fund approaches the management of its investments as if they constituted the complete investment program of the prudent investor.” The prospectus for Dodge & Cox Balanced Fund refers to investors finding it “suitable for their entire long-term investment program.”

3) The Department of Labor has established “safe harbor” regulations for pension plans. The regulations set out certain investment alternatives that pension sponsors under ERISA are allowed to use for default options for employee pensions. The approved default categories in the DoL proposal - now known as qualified default investment alternatives (QDIAs) - include:

• lifecycle or targeted-retirement date funds,
• balanced funds, and
• managed accounts.

“The new default options will help workers accumulate larger nest eggs for retirement,” said [Assistant Secretary of Labor, Ann] Combs. “Workers who don’t feel equipped to make investment decisions will be automatically invested in a mix of stocks and bonds appropriate for long term savings.”

The basic idea is that balanced funds conform to the prudent investor rule and that employers, assuming they continue to monitor the investment managers, cannot be sued (hence “safe harbor”) for lack of suitability.

Clearly, if you own just one fund, a balanced fund is probably the best choice. A balanced fund would be the logical choice for the smaller accounts in your book, or as the first fund for a beginning investor. A balanced fund is also an excellent choice for a systematic investment plan, where the investor places a fixed dollar amount in a fund each month. (I think advisors who are not urging their clients to use a systematic investment plan alongside their other investments are missing the boat.) It would make sense to have a balanced fund in a 401k plan. Finally, a balanced fund can help protect you from legal liability.

Traditional balanced funds often stayed close to the 60% equity/40% bond mix. Modern balanced funds now often include international stocks as part of the equity mix and have some latitude to change the mix slightly over time.

Fun fact: the first balanced fund was started by a Philadelphia accountant named Walter Morgan. He was the founder of Wellington Management. Vanguard’s Wellington Fund is still one of the largest balanced funds today.

Most of the giant balanced funds in the investment industry are large because they have had long track records of superior performance. Some of the largest funds currently are Capital Income Builder ($58 billion), Income Fund of America ($51 billion), Franklin Income Fund ($33 billion), American Balanced Fund ($30 billion), Vanguard Wellington Fund ($28 billion), Fidelity Balanced Fund ($17 billion), and Dodge & Cox Balanced Fund ($14 billion). [These asset numbers came from Lipper.] Chances are that you have holdings of one or more of these funds in your book.

Each fund approaches the balanced mandate slightly differently. Franklin Income Fund tilts toward a large chunk of fixed income (55% of the portfolio), including a slug of high yield bonds. Capital Income Builder has the largest part of its equity investments overseas (39% of the portfolio), while Dodge & Cox Balanced Fund stays close to home (61% of the portfolio). [This asset allocation information came from Morningstar.]

The Arrow DWA Balanced Fund (DWAFX) has a similar mandate. Like all balanced funds, we have a minimum of 25% bond exposure at all times. However, there are a couple of things we do rather differently than many balanced funds.

1) Different from most balanced funds, DWAFX has a sleeve dedicated to alternative assets. This is because the fund is run along the lines of the Yale Endowment model, with a very broad mix of investable asset classes. Right now those alternative assets (19%) are gold and real estate, which have been quite additive to returns.

2) Different from most balanced funds, DWAFX allocates assets dynamically based on relative strength. The four sleeves within the portfolio-domestic equities, international equities, fixed income, and alternative assets-can have their weights vary dynamically within broad bands depending on the strength of the asset class. For example, right now the bond allocation is 27%, but it has been as high as 52% during periods of market stress. Similarly, the international equity allocation is currently 21%, but it has been as high as 38% during periods of U.S. dollar weakness.

Here’s a snapshot of DWAFX’s allocation as of 9/30/10:

Source: ArrowFunds.com

We think systematic application of relative strength across a broad range of asset classes-otherwise known as global tactical asset allocation-within a balanced fund can be a superior strategy for an investor that is looking for a complete investment solution. Although the Arrow DWA Balanced Fund does not yet have the long tenure of many of the other excellent balanced funds, performance has been strong since inception. (For an interactive price chart of performance of DWAFX versus the other industry heavyweights, click here. Select “max” under the chart to see full performance since inception.) We hope that at some point in the future we will be mentioned in the same breath as the other top balanced funds.

For information about the Arrow DWA Balanced Fund (DWAFX), click here. Click here for disclosures. Past performance is no guarantee of future returns.

This entry was posted on Monday, November 15th, 2010 at 1:08 pm and is filed under From the MM, Tactical Asset Alloc. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.