In recent years, many investors have turned to balanced funds to navigate a challenging market environment. Although the U.S. remains a bright spot in global financial markets, low bond yields have made income generation more difficult while equities on the whole appear fully valued following a sharp run-up since the financial crisis. Managers of balanced funds can more nimbly explore evolving opportunity sets using both allocation and security selection. In this Q&A, three portfolio managers with American Balanced Fund® discuss their investment approach in the current environment, including:
- The outlook for U.S. equity and bond markets
- Notable areas of opportunity within equities and bonds
- The key drivers of their asset allocation process
Readjust Expectations for Equity Returns
Generally, how do you think about asset allocation in a balanced fund?
Greg: We consider ourselves to be stock pickers first and foremost. For most periods in the fund’s history, we have added value by investing in the right stocks and bonds based on a fundamental, valuation-based approach. Having established that, we have the flexibility to move between stocks, bonds and cash in a material way when we think it is appropriate, and we do exercise it.
We expect that, in most years, the asset allocation split between stocks and bonds will fluctuate in a pretty tight range. We consider the anchor point to be 65% equities and 35% bonds and for the asset allocation to fluctuate around that. However, we can meaningfully deviate from that if we think it’s the right thing to do. But that would be the exception.
What are the few times that the fund has experienced such a dramatic shift in asset allocation?
Greg: One period was the late 1990s, when the then-principal investment officer, Bob O’Donnell, got very worried about the market, leading us to reduce equities to around 50% of the fund’s assets. It was the right call given the ensuing bursting of the tech bubble. Then, in 2013, we went into the year with 71% of the fund’s assets in equities because we thought stocks were attractively valued. We’ve gone the other way since the end of 2013, reducing stocks to as low as 53% earlier this year.
What is your expectation for U.S. equity returns over the next several years? And how does that influence the fund’s asset allocation?
Greg: Given the current environment, I think U.S. equities likely will deliver returns that are below historical averages, for two reasons. Firstly, valuations are above the historical mean, so you are starting with a price-to-earnings (P/E) ratio that is higher than the historical average. Corporate profits as a percentage of gross domestic product are close to all-time highs — and all else being equal, corporate profits can’t indefinitely grow faster than nominal GDP. Secondly, 10-year U.S. Treasury rates are dramatically lower than the long-run average, and eventually they will move higher. Interest rate increases affect stock prices by reducing the present value of a stock’s cash flow and making bonds relatively more attractive.
Now, if equity results return to somewhat below their long-run average — say, 3% to 5% — without much inflation, that’s still not a bad number; it’s just not as high as many investors may be used to. So, I think an approximately 60% allocation to equities and 40% allocation to bonds would be appropriate on average because I am not as confident that equities are going to outpace bonds by as much as they have in the past.
What do you see as this balanced fund’s main mission?
Greg: Essentially, we strive to grow investors’ wealth without scaring the heck out of them. We know from behavioral finance that many investors react to sharp market movements in counterproductive ways, such as pulling out at the bottom of a market. So, we seek to grow people’s wealth in a prudent way regardless of the market environment. The first three words of the fund’s objective are “conservation of capital,” and we take that objective very seriously. I worry less about lagging in up markets than I do about our goal of delivering consistent returns with lower volatility. The other elements of the fund’s objective are current income and the long-term growth of capital and income.
What’s the process for significantly changing the asset allocation?
Greg: As I mentioned earlier, in most periods the asset allocation will be an outcome of bottom-up security selection. Stock weightings will move higher if we are finding a lot of value in companies and vice versa. We firmly believe that a valuation-based discipline adds the greatest value.
From a top-down perspective, there are a few ways in which asset allocation happens. As the fund’s principal investment officer, I can adjust the asset allocation when I have a strong opinion that is different from where the fund is positioned. I do this in consultation with the team of portfolio managers in the fund. We can adjust the asset allocation by either re-allocating funds among the equity and bond managers or directing new fund flows to them. To an extent, that will depend on whether we want to make a rapid shift or implement it in increments over a period.
On many occasions, the change is organic. For example, by and large, 2013 was a year in which equities did dramatically better than fixed income, and we opted not to rebalance as it was happening. Also, we have one portfolio manager — Hilda Applbaum — who can invest in both stocks and bonds, so her decisions will also shift the allocation.
How do the equity portfolio managers complement each other?
Greg: I think we have a good mix of styles among the managers. For example, many of the equity managers invest quite differently than I do. I tend to have a fairly concentrated portfolio with somewhat of a growth bias.
One of the equity managers is very comfortable investing in deep cyclicals, given her background as an analyst on industrials and other cyclical industries. Another equity manager tends to have a value orientation, with a greater focus on dividend yield. The managers also covered different industries ranging from oil to technology as investment analysts. That brings different perspectives.
How is the goal of conservation of capital reflected in the equity strategy?
Greg: I think the equity portfolio plays a role in capital conservation because it is focused on both growth and income. Over the last two years or so, we have added to more defensive sectors with above-average dividend yields that typically do better in bear markets, like consumer staples. I manage a meaningful slice of the fund and I can also adjust my sleeve to help strike a balance. If I don’t think the fund is aggressive enough, I can make my equity portfolio more aggressive, and if I think we are too aggressive, I can make my portfolio more defensive.
Asset Allocation Using a Valuation-Based Discipline
What’s your view of valuations and the general investment environment for U.S. equities?
Hilda: I think the U.S. equity market as a whole is fairly valued. I am encouraged that we are in a sustainable, moderate growth trajectory in the U.S. But we are not immune from the rest of the world, whether it is Brexit or unrest in the Middle East, to cite just two examples. This slow, moderate growth will be good, but not great, for corporate America. I believe that in this environment, our ability to add value will come primarily through security selection backed by fundamental research.
Where are you seeing appealing opportunities in equities?
Hilda: I’m finding some interesting companies in health care. Although one must be conscious of political and regulatory risks in the sector, I like select insurers that should benefit from health care reform. I am invested in several pharmaceutical companies with promising drug pipelines. Beyond health care, I have also been gradually raising my investments in energy, as I have seen some improvements in capital allocation among select energy companies.
In deciding to adjust the fund’s asset allocation, what is the process and what are the inputs?
Hilda: We hold regular meetings among the equity and fixed income managers and analysts, along with our macro-economic researchers. In addition to discussing the size of the allocations to stocks and bonds, we think about the positioning within each asset class. So, for example, we discuss not only how much we want to have invested in bonds, but also the overall bond positioning. Do the bonds reflect our outlook for markets and interest rates, for example, and the role that bonds are playing in the fund in the context of that market environment?
How do you see your role as a manager in the fund who invests in both stocks and bonds?
Hilda: As a hybrid equity-bond manager, I influence and inform on the relative attractiveness of equities, bonds and cash. Our fixed income managers focus on their positioning within the bond market, not on how much fixed income they want to hold. The equity managers think a little more about the size of their equity exposure, but their movements to cash reflect their view of the equity market, notof the relative attractiveness of bonds and equities.
Being a hybrid manager, to the extent that there are movements among those asset classes within my portfolio, those changes can be launching points for broader asset allocation discussions among managers. The broader asset allocation in the fund is a decision of the principal investment officer in consultation and collaboration with the fund portfolio managers.
What do you see as the fund’s neutral allocation? And to what extent would the fund deviate significantly from that?
Hilda: We see the neutral allocation as around 60% to 65% equity, although the fund can go as high as 75% equity. I think a 60%–65% equity position reflects academic research about asset allocation, but it also reflects our intention to offer shareholders a true balanced fund. This is not an opportunistic asset allocation fund. We expect the fund to be about 60% to 65% in equities in a normal market environment. If the fund is at 75% equity or 50% in equities, we would have to believe that there is something exceptional about the market environment.
Finding Opportunities in Today’s Bond Market
How do you see the role of fixed income in American Balanced Fund?
John: In American Balanced Fund, fixed income’s main role is reducing equity volatility, as bonds tend to move in the opposite direction from stocks. We manage the bond portfolio to dampen volatility, not just to maximize fixed income returns. To accomplish this, we maintain a true core fixed income portfolio, including high-quality U.S. Treasuries, mortgages, asset-backed and corporate securities. We want to do as well as we can within a core portfolio providing yield and total return, but we do so in the context of offsetting equity volatility. That means maintaining high quality and keeping some duration in the portfolio.
How much does the future trajectory of U.S. interest rates factor into your decision-making, and what’s your view on rates going forward?
John: Even during times of rising interest rates, bonds should play a key role in balancing out equity volatility and providing a smoother ride for long-term shareholders — that’s really at the core of how we manage the bond portfolio. That said, I don’t necessarily think that interest rates are going to go much higher in the U.S. in the near future, given economic weakness and ultra-low or negative interest rates in several major economies of the world.
In your view, what are some attractive opportunities in fixed income today?
John: We find U.S. Treasury Inflation-Protected Securities (TIPS) attractive. We believe that break-even inflation rates are very low relative to what we expect actual inflation to be over the next six months to a year.
Another area is corporate bonds. Overall, we think corporates are fairly valued, especially given the leveraging we have seen among corporations and given how narrow the yield differential is to Treasuries. Nevertheless, we are finding some appealing opportunities, including companies that are either deleveraging or offering more yield than we think their current credit quality warrants. We are also finding interesting opportunities in energy, especially in areas that should not be as tightly correlated with energy prices, such as pipelines.
Select areas within asset-backed securities also offer attractive yields and spreads, in our view. Our analysts are seeking to identify issuers with strong underwriting standards and credit enhancements. In addition, we have invested in some highly rated commercial mortgage-backed securities, which have offered some appealing incremental spreads.
The bond portfolio has a lower exposure to mortgage-backed securities relative to the index. While they may offer a little bit of incremental yield, if we get a lot of volatility in the Treasury market, mortgage-backed securities will lag Treasuries, and they could fare worse than what is priced in those securities today. Yield spreads to Treasuries have remained narrow because the Federal Reserve still owns a huge percentage of the mortgage market.
With rates being so low, how are you thinking about income in the bond portfolio?
John: We are always thinking about income, because income is a primary source of return for bonds. At the same time, we can’t stretch for income simply because interest rates are low. In fixed income, every bit of incremental yield comes at the expense of incremental risk, such as credit quality, liquidity, prepayment risk in the mortgage market and differing structural protections. And that additional risk can result in increased equity correlations and make the portfolio more sensitive to volatility and credit spreads. That would be inappropriate given fixed income’s important role in offsetting equity volatility.
When making fixed income investment decisions, how do you balance top-down economic factors with a bottom-up fundamental approach?
John: Over any moderate length of time, fixed income returns are dominated by macro events. Do rates go up or down? Is the curve shifting up or down? Are broad corporates getting more or less attractive?
So, when we talk about valuation sensitivity, we really are talking to a significant degree about macro issues. Portfolio duration and sector allocation will be determined by these macro factors — whether we have 25% to 30% in U.S. corporates or in mortgages. But within that 25% to 30%, our positioning will be based a lot on bottom-up security-level analysis — identifying attractive companies that are deleveraging or mortgage pools with some prepayment protections, for example. We devote considerable resources to the top-down analysis, like all fixed income investors, but we also put an incredible amount of effort into research at the security level. It is this combination that we believe is essential to our ability to add value over time.
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