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A Better Balanced Benchmark

Onfo - Craig Israelsen

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A Better Balanced BenchmarkCraig L. Israelsen, Ph.D.March 24, 2009It’s time for a better benchmark for “Ba lanced” funds. Way back when, there were two dominant investment assets: US stock and US bonds. These two assets became the mainstay ingredients in balanced funds, with the typical ratio being a 60% allocation to large-ca p US stocks and a 40% allocation to bonds. News flash: it’s not 1959 anymore. Today, there are multiple mainstream asset classes that should be considered when building a diversified balanced st benchmark. Shown below are 12 asset classes that should be included in a 21century balanced fund. The 12 ingredients that belong in a balanced fund fall within seven core asset groups: US equity, Non-U S equity, Real Est ate, Resources, US Bo nds, Non-U S Bo nds, and Cash. Within the seven core asset groups are 12 specific sub-a ssets (se e “Ba lanced Remix”).Balanced RemixApproximately 65% of the Portfolio Allocation Approximately 35% of the Portfolio in Equity and Diversifying Assets Allocation in Bonds and CashUS Non-US Real US Non-US Resources CashEquity Equity Estate Bonds BondsLarge Developed Global Natural US Aggregate International US Money Companies Markets Real Estate Resources Bonds Bonds MarketInflation Medium-sized Emerging Commodities Protected Companies MarketsBonds (TIPS)Small CompaniesBa lanced funds are one of two structures meeting the requirements of a qualified default investment alternative (Q DIA) ...

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Nombre de lectures	38
Langue	English

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A Better Balanced Benchmark

Craig L. Israelsen, Ph.D.

March 24, 2009

It’s time for a better benchmark for “Balanced” funds. Way back when, there

were two dominant investment assets: US stock and US bonds. These two

assets became the mainstay ingredients in balanced funds, with the typical ratio

being a 60% allocation to large-cap US stocks and a 40% allocation to bonds.

News flash: it’s not 1959 anymore. Today, there are multiple mainstream asset

classes that should be considered when building a diversified balanced

benchmark. Shown below are 12 asset classes that should be included in a 21

century balanced fund. The 12 ingredients that belong in a balanced fund fall

within seven core asset groups: US equity, Non-US equity, Real Estate,

Resources, US Bonds, Non-US Bonds, and Cash. Within the seven core asset

groups are 12 specific sub-assets (see “Balanced Remix”).

Balanced Remix

Balanced funds are one of two structures meeting the requirements of a

qualified default investment alternative

(QDIA) under the provisions of the

2006 Pension Protection Act (PPA). The other QDIA is a target date fund. In

addition to their built-in “glidepath” (i.e., dynamic asset allocation model) a

Approximately

65%

of the Portfolio Allocation

in Equity and Diversifying Assets

Approximately

35%

of the Portfolio

Allocation in Bonds and Cash

Equity

Non-US

Equity

Real

Estate

Resources

Bonds

Non-US

Bonds

Cash

Large

Companies

Developed

Markets

Global

Real Estate

Natural

Resources

US Aggregate

Bonds

International

Bonds

US Money

Market

Medium-sized

Companies

Emerging

Markets

Commodities

Inflation

Protected

Bonds (TIPS)

Small

Companies

common attribute of target date funds is broad diversification across many asset

classes. Balanced funds don’t have a glidepath because their allocation stays at

or near the 60/40 level over time. However, balanced funds should be utilizing

multiple asset classes to gain the benefits of true diversification. The current

reality is that most balanced funds are not broadly diversified because they are

based on an outdated model which typically employs only two asset classes: US

large-cap stocks and US bonds. You know the drill: 60% S&P 500 and 40%

Lehman AGG (now Barclays Capital AGG). We can do better.

Furthermore, even if there were a wide selection of broadly diversified balanced

funds, there is a scarcity of multi-asset class balanced indexes for use as

performance benchmarks. Most providers of balanced funds simply create a

benchmark index by blending a large-cap US index with a bond index and then

refer to that performance cocktail as a “balanced index.” It is odd that a QDIA

would not have a clearly identified benchmark index. This glaring lack of a multi-

asset class balanced index is particularly noticeable in light of the fact that the

other QDIA (target date funds) are increasingly employing multiple asset classes.

Not surprisingly, an evolving set of target date “indexes” are portfolios comprised

of multiple asset classes.

We have entered a new era. Whereas single asset class indexes (e.g., S&P

500, Russell 2000, Barclays Capital Aggregate Bond Index, MSCI EAFE, etc.)

have been the standard approach to this point, the evolution of multi-asset class

portfolios demands the development of multi-asset class benchmark indexes.

This article introduces a multi-asset class balanced portfolio that brings a higher

standard to the important mutual fund category long known as “balanced:” the

“7Twelve Portfolio.” The name makes reference to “7” core asset classes with

“Twelve” underlying sub-assets. The 7Twelve Portfolio is constructed to

generally follow the time-tested 60/40 guideline, but uses eight sub-assets

(instead of one) to create an overall equity exposure of approximately 65% and

four fixed income sub-assets (instead of one) to create a “bond” exposure of

approximately 35%. All 12 sub-assets are index-based exchange traded funds

and are all equally weighted (each representing 8.3% of the 7Twelve portfolio).

Equal-weighting is maintained by annual rebalancing. The difference between

the old school balanced benchmark and the new age balanced benchmark are

depicted in “Old School vs. New Age”.

Old School vs. New Age

The performance of the multi-asset class 7Twelve Balanced Portfolio has been

significantly better than a standard 60/40 balanced portfolio over the past 3, 5,

and 10-year periods (see “Better Balanced”). The Vanguard Balanced Index is a

representative fund using the standard 60/40 balanced approach. The Vanguard

500 Index is a clone of the S&P 500 Index, and is included simply for context.

Over the five-year period from 2004-2008, the 7Twelve Balanced Portfolio

averaged a 5.00% annualized return, whereas the Vanguard Balanced had a

0.96% average annualized return. The Vanguard 500 Index produced an

average annualized return of -2.29% over the past five years. For the 10-year

period ending on December 31, 2008 the 7Twelve Portfolio had a return nearly

500 bps higher than the Vanguard Balanced fund and nearly 850 bps higher than

the Vanguard 500 Index. As shown in “Over the Top,” a $10,000 investment in

the 7Twelve Portfolio in 1999 grew to nearly $20,000 by the end of 2008,

compared to $12,279 in the Vanguard Balanced fund, and $8,630 in the

Vanguard 500 Index.

Better Balanced

Calendar Year

Total % Return

7Twelve Balanced

Portfolio

Vanguard

Balanced

Vanguard

500 Index

1999

16.06

13.61

21.07

2000

6.78

(2.04)

(9.06)

2001

(1.68)

(3.02)

(12.02)

2002

(0.69)

(9.52)

(22.15)

2003

27.00

19.87

28.50

2004

17.77

9.33

10.74

2005

12.20

4.65

4.77

2006

15.35

11.02

15.64

2007

11.30

6.16

5.39

2008

(24.75)

(22.21)

(37.02)

3-Year Return (2006-2008)

(1.14)

(2.85)

(8.44)

5-Year Return (2004-2008)

5.00

0.96

(2.29)

10-Year Return (1999-2008)

6.97

2.07

(1.46)

10-Year Growth of $10,000

$19,617

$12,279

$8,630

Building a more diversified

balanced

portfolio enhances the inherent virtues of

the classic 60/40 balanced model. As a result of the Pension Protection Act, the

usage of balanced funds as a default investment vehicle will increase among

retirement plan sponsors and among the general investing public. In fact, at the

end of 2008 there was approximately $170 billion invested in balanced funds.

Interestingly, the largest 10 funds held nearly 80% of all the assets. The average

10-year performance of these 10 largest balanced funds from 1999-2008 was

3.74%, whereas the 7Twelve Balanced Portfolio generated a 10-year return of

6.97%.

Better “balanced” performance is not the result of skill, but simply the natural

byproduct of meaningful diversification and systematic rebalancing. The 7Twelve

Balanced Portfolio is not only a better benchmark for balanced funds, it’s also an

investable product

Over the Top

Craig L. Israelsen, Ph.D. is a professor at BYU. He is a principal at

Target Date

Analytics

and the designer of the

7Twelve Portfolio

www.advisorperspectives.com

For a free subscription to the Advisor Perspectives newsletter, visit:

http://www.advisorperspectives.com/subscribers/subscribe.php

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