Honest Money
Honest Money
Balanced Funds Unpacked: Diversifying for Long-Term Financial Success
In this episode, Warren Ingram and Rupert Hare, Head of Multi-Asset at Prescient, discuss the significance of balanced funds in investment portfolios, particularly for retirement planning. They explore the structure of balanced funds, emphasizing their role in providing diversification across various asset classes. The discussion also covers the importance of understanding market volatility, the long-term focus required for successful investing, and the tax implications associated with balanced funds.
Takeaways
- Balanced funds are essential for most investors' portfolios.
- They provide diversification across various asset classes.
- Investors should expect market volatility with balanced funds.
- Long-term focus is crucial for successful investing.
- Tax efficiency is a significant advantage of balanced funds.
- Understanding the risk-return profile is vital for investors.
- Fees can significantly impact investment returns over time.
- Diversification helps mitigate risks associated with market fluctuations.
- Investors should not panic during short-term market downturns.
- A balanced approach is key to achieving retirement goals.
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Speaker 2:Welcome to Honest Money. I'm very happy to be joined again by one of Honest Money's favorite guests, Rupert Hare. He's head of multi-asset at Prescient Investment Management. Welcome, Rupert. Thanks so much for making the time to join us again.
Speaker 3:Thanks so much, Warren. Always a pleasure to be here.
Speaker 2:So we're talking about? We rarely talk about product actually in HonestMoney we focus on education and the like, but I think the one product that probably would feature in most people's lives in one form or another would be the classic balanced fund, whether it's a balanced unit trust, a balanced portfolio if it's in a retirement vehicle, et cetera. But we're talking about balanced funds and the reason that it would feature in most of our lives in one form or another is that it's usually the core holding of most large retirement funds. So you know, if you work for a very big business and you've got a company retirement fund, it's very likely that it looks like a balanced fund. It might even be a selection of balanced funds and when people do retirement planning for retirees, very often the bulk or a significant portion of their money would be invested in balanced portfolios or balanced funds.
Speaker 2:So, long story short, these things are very valuable number one. But number two, very important in our lives and I think you know before we started the recording, rupert mentioned that we've probably discussed this in one form or another before, but I think it's a critical point is to understand them, to understand why they're important and to go through. So there isn't someone I know better that will actually talk to me than Rupert to help us with this understanding. So that's the topic, rupert, thanks so much for making the time, and I thought maybe let's just kick off with what is it why, like? Why does this thing work? Why do we have it in our portfolio?
Speaker 3:Yeah, so it depends on the person, the investor. But I guess for the most part, as you mentioned, a lot of investors, so probably the bulk of investors around our industry, in particular in South Africa, will have balanced funds as a core within a portfolio. And why is that? Well, they have got a little bit of everything in them. So you've got access to different asset classes equities. So you've got access to different asset classes equities, bonds, property, onshore, offshore and they're really designed to try and maximize your probability of hitting things like retirement goals. So generally, you'll have balanced funds in retirement type products. They are generally Rake 28 compliant, which means that they are allowable within your pension fund, and then designed exactly for that. So they're designed to provide you with a stable journey into retirement.
Speaker 2:Okay. So we look at something that gives us proper diversification. That's the point. It's got these underlying investments that are not just exposed just to cash or just to bonds, just to listed property and equity. It's got a mix of everything.
Speaker 2:I guess one comment there, rupert, is that when you're in the unit trust world and you say balanced fund, it also means something from the point of view that there is going to be a range. There's going to be the minimum amount that someone could invest in a balanced fund to shares and a maximum, and then the same across all the other asset classes as well. And I think for me that's an important point because it also tells you the kind of potential downside. I guess when you're investing in a balanced fund, it means you've got a significant exposure to local and global stock markets, which I think is the absolutely right thing to do for any decade it doesn't matter which decade, but for any long-term investor you should have a high exposure to shares. But it also tells you that over a three, six, 12-month period, if stock markets go down and they can halve and you've got a balanced fund, it means there's a good chance that your balanced fund is down 10% to 20% over a few months.
Speaker 2:It's not to say that your money's lost. I think that's the key point here. It should recover, but you should be ready for that. It's going to give you good growth over for that. It's going to give you good growth over a decade. It's also going to give you a rollercoaster ride where you're going to open your statement one day and see your investment down, and that's normal. If we did a podcast about that in the middle of a big stock market crash, you and I would be sitting here saying don't do anything. You're in a balanced fund. It's the right thing. Just keep going.
Speaker 3:Fair assessment. Well, let me just I mean one revision there. I wouldn't call it a roller coaster, let's call it a boring roller coaster. There's going to be a bit of ups and downs, but you know, if you're directly in the equity market and if you're in the equity market and let's say very small stocks, illiquid stocks, in crazy markets, then yes, that's a serious roller coaster. But my job in creating balanced funds is to smooth out that roller coaster journey as best as I can. And that's important for someone who's both pre and post retirement, because you may be contributing or you may be withdrawing from that balanced fund on a continuous basis. So think about it. If you're withdrawing, for example, you could be withdrawing at the bottom of that roller coaster journey, which means that you're getting less money out in a particular month. Likewise, when you're contributing, you could be at the very top of that roller coaster, which means that you experience immediately thereafter a big dip. So we're trying to smooth out that journey and to do that really.
Speaker 3:The idea behind a balanced fund is to maintain a balance journey and to do that really. The idea behind a balanced fund is to maintain a balance. I mean, if you were to have one asset class, let's say equities you have what I would think would be and sorry for those that run pure equity funds, but for the purposes of this conversation it's an imbalanced fund, right. And then you could argue the same thing on a cash or money market or income fund. It's an imbalanced fund. But sometimes you want an imbalance. So at the early stages of a career you want massive growth profiles you don't have to draw down from a portfolio, and then perhaps you want to go into equities. At the late stages, when you're withdrawing from your portfolio, then an income fund is a fantastic opportunity because you reduce the volatility. But somewhere in between comes balanced funds, and that's where we try and combine the best cocktail of different asset classes for the smoothest journey for the investor.
Speaker 2:So I mean, I guess it's a fair point that the roller coaster is limited.
Speaker 2:But I guess, for a lot of people who are relatively new to investing whether you're a retiree and you've never worried about actually investing before, you've just been saving and all of a sudden you're a professional investor now because you're living off your retirement money or people new to investing, understanding that if you want your capital to grow faster than inflation, you need to be prepared that it doesn't go up in a very nice straight line.
Speaker 2:It will go up and down and if you looked at it almost as a graph, that it will look like sort of a saw blade.
Speaker 2:It will go up and down but generally from over longer periods of time it will be going up in a good direction. And so, understanding that I'm still going to call it rollercoaster Rupert, I'm stubborn there but that short term rollercoaster ride is the necessary and it's not necessarily big pain, but it is necessary pain to beat inflation, to get that capital growth. And so I agree with you that the the skill for a fund manager would be how do I get that combination of the assets right so that the down is as small as possible and the up is as high as possible. But me, as the eternal critic, will tell everybody that there will always be downs, and if there is never a down, you're probably in a pyramid scheme and you're probably in a Ponzi scheme. If you're beating inflation as your goal, it has to go down and that's okay Like it's it's, that's normal. It's a necessary thing to know that you're in the right kind of investment.
Speaker 3:Yeah, 100% right, and I think just to be, to be a humble investor, to be a humble portfolio manager for me is so important, and what I mean by that is there are so many things outside of my control. I wish I could control the US elections, but unfortunately I cannot. So that is a short term outcome where the market might react to, let's say, president, secondary president or the 47th President, donald Trump in control of the United States again. But really what we try and do with imbalanced funds is to focus on the medium to long term. So what do I mean by that? I mean sort of three, four, five years and beyond. So if you're going to be the type of investor that opens the statement every week and worries about those ups and downs on your saw blade, you know that's going to cause you unnecessary stress. What you should be looking at is whether the fund is giving you what you need, that being a proper inflation beating return over the longer term, and longer term being, let's say, five years and beyond. And that's where you're trying to plan and save for retirement or post-retirement. You will be planning and saving for your holiday overseas or whatever it might be, but it's a longer term fund and you get shorter term funds and you get extremely long term funds.
Speaker 3:But the key here is that it's balanced. So, for example, within the portfolios that I managed let's go through some numbers here Always love big numbers we invest in over 20 different markets. We invest in over 5000 different stocks and we invest in over 20,000 different fixed income issuances. So we try and keep a balance so that we don't have concentration. And, by way of example there, if we were 100% concentrated in South Africa, no matter how bullish I might be on South Africa and right now I'm pretty bullish on South Africa but things can go wrong. We know that the GNU can fall apart. Touch wood that it doesn't, but it can, and that's why you need to diversify portfolios, especially in retirement products need to diversify portfolios, especially in retirement products.
Speaker 2:Yeah, I think it's a powerful point around understanding that you could have a view about the world and over a decade your view might be right, but over a year your view could be completely wrong, just because events don't pan out exactly on schedule. And so having that humility which I'll say is rare in fund managers so well done, Rupert. But you know, having the humility to know that actually very often your views will pan out over time they don't necessarily pan out when you'd like them to. You know, over a short period of time is key, and that's where the balance comes in. Balance comes in, and so I won't put words in your mouth.
Speaker 2:But when I look at balanced funds as a selection and I look at their returns over meaningful periods in other words, five years, but definitely 10 years for me, is always a good indicator. I would expect that a decent balanced fund is delivering a return in a range of about, let's say, 9% to 11% a year. A return in a range of about, let's say, 9% to 11% a year. And that's no guarantee. As I said at the start, it's going to be sometimes much higher and sometimes much lower, but when people are doing a projection and they've got a decade or two to kind of put a number in their growth profiles, then I think that that's a fair assumption. So I'm not going to ask you to comment on that.
Speaker 2:But I think what is valuable to know about that is, if inflation is running at 6% and we'll all argue about our own personal cost of living rate of change, but let's just say it's 6% it means that you're expecting your capital to grow faster than your cost of living is rising, and that's the key here. So if you're drawing money, if you are retired and you're drawing from your portfolio and you can draw, let's say, 5% a year and your cost of living is going up at six, that's pretty much the profile of a balanced fund over a decade or two. And that's the power of, firstly, the long term, secondly, the asset mix. And so you know understanding that it is a very useful planning tool for people that are building, so accumulating capital, and then those that are drawing money.
Speaker 2:But I think we need to talk about the dreaded T word around the taxes. People love putting their money into kind of a fixed deposit or a money market account because it never goes down. And my immediate comment after that is you're absolutely right, but just look at the tax that you pay, and so tax is the great destroyer of personal portfolios if you don't focus on it and you don't pay attention. We all have to pay a tax, but you want to do it within reason, and so maybe just to understand what's the tax implications of a balanced fund.
Speaker 3:It's only within fund wrappers and when you invest in a fund as opposed to going directly into the market, and it depends on the different structures that you're investing in or via. And it depends on the different structures that you're investing or via. But let's give you an example. If I'm a discretionary investor and I'm investing into a fund or a stock or a bond, if I need to sell down that stock so say you invest in Tesla or Nvidia or whatever it might be and you need to sell down that stock to rebalance your portfolio and you're outside of a fund then you're going to be realizing tax.
Speaker 3:Now, tax, as you say, you have to pay tax at some stage, but the better time to pay tax is as late as possible Because you get that CPI plus profile. You've got a higher base to accrue that from. So within a fund wrapper, you don't realize the tax. When a portfolio manager like myself is selling down equities to buy bonds, you do realize some of the tax, so there's a pass-through on incomes, but you don't realize the capital gains. And that's really the biggest benefit, or one of the biggest benefits, of investing in a fund, because it allows myself, as a portfolio manager, to make those decisions without fear or favor, and then for you, as an investor, to also not have any fear, hopefully, or minimize the fear of paying your taxes upfront and to push it all the way to the back, so that you have a much higher capital base to enjoy living off of.
Speaker 2:And I think maybe the other comment there is that the mix of assets in a balanced fund because there will generally be a higher allocation to shares it means that the ultimate interest that someone in a fund a balanced fund would pay will be relatively low because their interest income will be generated.
Speaker 2:In a balanced fund, there will be some bond exposure, which means that your bonds are paying interest as well, and potentially, if there is a property fund, you might earn some taxable rent in the fund. All of that then gets accumulated and there is a distribution from the fund to the investor where you will pay some interest or some income tax, but it should be fairly low. And I think that that's the key in a situation like this is where you're getting distributions. Those distributions are quite efficient from an income point of view and definitely over time the distributions also grow. And it's one of the things that I think people don't always focus on is that funds do pay out an income. The bulk of what you're expecting from a balanced fund is capital growth, so the income is not the main focus. But over a 20-year period, it's interesting for me to note that how that income actually rises, and certainly when you look at it relative to inflation, it's a meaningful number.
Speaker 3:Yeah, definitely. So it's a mix. Again, it's a balance of taxing during the fund's investments, although you want to minimize that as much as possible, so you do get some incomes and then taxing right at the end by selling down the fund itself.
Speaker 2:Yeah, and the real benefit there is if it's not in a retirement fund and you're paying tax on the growth. You're generally paying capital gains tax and even if you're a really big taxpayer, that means you're paying around 18% on capital gains as opposed to 45% on income tax and, as I said at the start, you really want to pay the least amount of tax you have to, and so 18 for me sounds a lot better than 45 with my simple math. So I mean I must say you know, I said it at the start I think it's a core holding for a lot of people you know in South Africa and certainly worth focus on. And I take your point as well, rupert.
Speaker 2:If you're 25 and you've got no debt and no dependence, et cetera, possibly you want to go with a higher allocation to shares. You might have a maximum allocation to local and global markets, but as people get a little older, having that spread is just, I think, a phenomenal benefit in terms of smoothing the ride of market volatility and that has a huge psychological impact on us. So the more we can stay invested and not panic, the better for us. And I know it's been a specific focus for the show, but I just think it's worth saying to you listener, this is the thing. This is the thing that you will have in your retirement funds and be happy with it. Make sure it's the correct one and the fees are reasonable, but it should be a core holding for decades to come.
Speaker 3:Yeah, and you hit the nail on the head there in the last point. I think there are a lot of balanced funds in South Africa. In fact, within the high equity space, which is the most popular, there are 220. So you have a lot of them to pick from. And one of the keys, for us at least, is try to minimize those fees, because if you're paying a full fee load of 3%, 4%, 5%, which some people do, you mentioned earlier that you're getting inflation plus 4% or 5%. That erodes very quickly. So you can access funds at very, very efficient fees.
Speaker 3:And that's just to another point that I thought of earlier. So if you're a direct investor and you want to buy and sell shares, you pay significant costs to buy and sell those shares. Unfortunately it's diseconomies of the small scale. So for us, we pay very little in trading within this fund and, most importantly, you pay nothing for buying and selling this fund. So on the way out and on the way in you don't pay a cent. So that's really important for us to pass that on to you. You don't have to worry at all about selling a stock because you're going to be paying, let's say, 50 basis points. So half a cent to a broker, for example.
Speaker 2:Yeah, and I think it's often a point people miss. They feel in control of their money because they're buying their individual shares and they see the profit go up, and then they're really disappointed when they look at the cash that they've put in their bank account after selling because actually they lost a fair amount in cost, especially if they do that relatively frequently and the sort of high frequency trading of people. One thing it does is it makes brokers very rich. So just be careful there with your costs. Costs are so subtle some of them and I think Rupert makes a great point there Buying and selling the fund. You don't pay transaction charges there and you'd be aware of your tax on your gains, but that's not a trading cost. Rupert, we're running out of time and I wanted to give you the opportunity just to wrap up if you had any final words of wisdom for us on balanced funds.
Speaker 3:Yeah, so I think we've covered quite a few points. But just to go back to the point of diversification, don't put all your eggs in one basket. I'll admit that in my investment career I have made that mistake. At times. Earlier on in my investment career I thought I was the king of the markets and why didn't I just do this? Why didn't everyone just do this? And you're making massive returns.
Speaker 3:But unfortunately, a lot of things are out of your control and it can be political, it can be company specific, it can be a lot of things and they really are out of your control. We call them exogenous risks and the way to avoid them as best as possible is to just diverse for your portfolio. So multiple asset classes, multiple geographies, no matter how good South Africa looks, no matter how good America looks. You don't want to put all your eggs into any of those baskets because we do go wrong.
Speaker 3:We have to be humble investment managers, and I'm a professional investment manager and I'll say that I don't get things right all the time. In fact, if an investment manager gets things right, more than 50% of the time you're winning. So that's what we're aiming for. And just a last point that you'll probably never hear from an investment manager about the stocks that lost, but I promise you that there are a lot of stocks that do lose in portfolios. And just to back Warren's point earlier, that just means that you shouldn't focus on the shorter term. It's going to cause you gray hairs. Rather, focus on the three, five, 10-year outcomes and try and design your portfolios, just like that.
Speaker 2:I remember a quote from one of the kind of all-time great investors was Sir John Templeton, and I think he said he calculated at the end of his very long career that as a very successful investor he made the correct decision 51% of the time.
Speaker 2:And so you know 50-50 benchmark sounds like just passing when you're writing exams at school, but 50% plus decision-making as a fund manager means you're doing very well. Rupert Hare, head of Multi-Asset at Prescient Investment Management, thanks so much for joining us. I, as always, love these conversations and I know our listeners do as well and it was great to chat to you.
Speaker 3:Yeah, thanks as always for having me on.