Does your balanced fund have these three essentials?

Balanced investment strategies – typically a combination of stocks for capital appreciation and bonds for income – are back on the docket after a year of strong returns in 2023. Following a tough year in 2022, the Morningstar U.S. Moderate Target Allocation Index returned 16.75% in 2023.

As we look to 2024 and beyond, investors should consider whether their balanced strategies have the following three elements that we believe will be essential to achieving strong risk-adjusted returns.

1. Equities with strong secular growth prospects

According to The Conference Board, U.S. real gross domestic product (GDP) growth is projected to slow from 3.1% in 2023 to around 1.2-1.4% in 2024 and 2025. If these forecasts prove accurate, the next couple of years will be the lowest-growth environment in the U.S. since the Global Financial Crisis (GFC), excluding the COVID-induced slowdown of 2020.

The slowdown in growth is to be expected as the effects of higher interest rates begin to be felt by consumers and corporations alike. There will be less of an economic tailwind for companies to grow earnings, so corporations that are too reliant on favorable economic conditions and a zero interest-rate policy are going to find the next 12-24 months challenging. Consequently, unmet expectations in the form of disappointing earnings announcements and soft revenue forecasts are likely to be punished.

Earnings growth is essential for long-term stock price appreciation. If the economic environment will not be offering much assistance, we think an active strategy focused on individual companies that can continue to grow earnings amid tougher economic conditions is vital.

Similarly, strong balance sheets are important at this point in the economic cycle – companies too reliant on debt financing will feel a greater squeeze on their bottom lines due to higher interest rates. We suggest investors focus on high-quality, multi-year secular growth companies, especially those driven by digital innovation, Artificial Intelligence, and strong research and development.

The primary role of the equity sleeve in a balanced fund is to provide capital appreciation. Therefore, we believe it is important that this part of the portfolio is positioned to grow, despite challenges in the broader economy.

2. A bond allocation that does its job

We believe a bond allocation within a balanced fund should perform two main duties: Maximize income while also limiting drawdowns during periods of stress in the stock market. A 100% allocation to risk-free U.S. Treasuries would satisfy the second duty, but not the first, as one would forego the additional income (or credit spread) that corporate and securitized bonds pay above the Treasury rate. On the other hand, a 100% allocation to high-yield bonds would result in the inverse problem – one would have a high level of income, but also a high drawdown risk due to the high correlation between high-yield bonds and equities.

Balancing these two duties is key to positioning a bond allocation to do its job. Unfortunately, fixed income benchmarks do not always achieve this balance. Therefore, investors might consider an actively managed bond allocation that sets out to achieve the required balance.

In the current environment, we think an active bond strategy should incorporate two significant trends.

First, the Federal Reserve’s (Fed) monetary policy pivot is likely to result in several rate cuts in 2024. While there is conjecture around the timing and extent of expected cuts, unless we experience a surprise spike in inflation, we believe investors can be confident that interest rates should trend down from here. This is broadly positive, as bond prices rise when interest rates fall, and means that investors can consider taking on more duration, or interest-rate, risk. (Longer-duration bonds benefit more from falling rates than short-duration bonds, all else equal).

Second, we believe securitized sectors look attractive relative to corporate bonds. Their higher-than-normal relative yields and spreads appropriately compensate investors for the risk of a slowing economy, with the commensurate fundamental stress a slowdown may place on corporations and consumers. Corporate bonds, on the other hand, appear to be priced for perfection (or very close to it).

As such, investors may consider increasing their exposure to securitized sectors relative to corporate bonds. In addition to their more attractive yields versus history, securitized sectors could rally if economic data surprises to the upside, while being less likely to disappoint as much as corporates if the economy stalls.

Finally, securitized sectors exhibit lower correlation to equities than corporate bonds, meaning they provide better diversification against equity drawdowns than typical corporate-heavy portfolios, further helping to manage volatility.

3. A flexible asset allocation mandate

The economy and financial markets are constantly in flux, and the relative value between equities and bonds is no exception. While equities are expected to outperform bonds meaningfully in the long run, they are subject to bouts of short-term underperformance and heightened volatility.

We believe a flexible mandate that allows an investment manager to adjust the equity-to-bonds mix in a portfolio to suit current conditions is essential. A flexible mandate may allow a skilled manager to reduce the equity weighting ahead of periods of spiking volatility and falling equity markets, which may result in lower drawdowns and better risk-adjusted returns in the long run. Similarly, having the flexibility to raise equity allocations during periods where the manager expects stocks to outperform may also contribute to better long-term risk-adjusted returns.

Conclusion

With the combination of a slowing economy and the Fed signaling its intent to cut rates in 2024, investors should be prepared for the opportunities – and the risks – that come with the new landscape. Being well-positioned in both equity and fixed income allocations, as well as in one’s overall equity-to-fixed-income mix, will be crucial as we move into the next stage of the economic cycle.

IMPORTANT INFORMATION

Actively managed portfolios may fail to produce the intended results. No investment strategy can ensure a profit or eliminate the risk of loss.

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Securitized products, such as mortgage- and asset-backed securities, are more sensitive to interest rate changes, have extension and prepayment risk, and are subject to more credit, valuation and liquidity risk than other fixed-income securities.