Striking the Right Balance: Modern Portfolio Theory and the Rise of Balanced Funds

Matt Patterson, co-founder Bryant Avenue Ventures, LLC
Matt is a co-founder of Bryant Avenue Ventures LLC, the creator of the Nasdaq 7 HANDL Index. In 2017 Bryant Avenue Ventures partnered with Strategy Shares to launch a target distribution ETF. Matt previously co-founded and served as Head of Investment Strategy and General Counsel of Accretive Asset Management LLC, the creator of BulletShares Indexes. Matt began his legal career as an Associate in the Corporate Department of Skadden, Arps, Slate, Meagher & Flom LLP. Matt holds an MBA from the University of Chicago, a JD from the University of Illinois College of Law and a BA from the University of Illinois.

In 1952, Harry Markowitz published his landmark essay entitled, “Portfolio Selection.” In the essay, Markowitz demonstrated that a diversified investment portfolio exhibits less volatility than the sum of its individual parts and offers investors an opportunity to earn greater risk-adjusted returns than they could otherwise earn through concentrated investments in specific securities or asset classes.

While Markowitz eventually won the Nobel Prize in Economics for developing modern portfolio theory, the mutual fund industry largely ignored his observations during the 30 years following the publication of “Portfolio Selection.” The obvious implication of modern portfolio theory—that investors should invest in diversified portfolios with multiple asset classes—gave way to a system in which individual mutual funds mostly focused on either equities or bonds (but rarely both) and employed active portfolio managers to differentiate fund performance relative to other similar funds. Investors seeking diversified solutions providing exposure to multiple asset classes found only limited fund offerings.

Size of the Market for Balanced Funds

In 1984, the Investment Company Institute (ICI), which compiles and publishes statistics on the investment funds industry, created a new classification to track funds that hold both equity and debt securities. At that time, assets in balanced funds[1]—which hold both equity and debt securities—made up only 3% of the $371 billion of total assets held by U.S. mutual funds.

The years since have seen steady growth in the market for balanced mutual funds, bolstered in part by a 2007 Department of Labor regulation that allowed businesses to make target date funds default options in company 401K retirement plans. Target date funds are balanced funds that seek to reduce risk levels as investors approach retirement. As of December 31, 2018, assets in balanced mutual funds had grown to nearly $1.4 trillion, or 7.8% of the $17.7 trillion of total assets held by U.S. mutual funds.

While balanced mutual funds have grown into trillion-dollar asset category, the same can’t yet be said for balanced Exchange Traded Funds (ETFs). In the early years of the ETF industry, most ETF sponsors focused on providing beta exposure to specific asset classes or categories. At the end of 2007, the first year the ICI reported statistics for balanced ETFs as a separate category, such ETFs held only $119 million in assets under management, representing just 0.02% of the $608 billion held by the entire ETF industry.

In the years since 2007, the investment management industry has seen significant growth on the part of registered investment advisers who use ETFs as building blocks to build balanced portfolios for clients. The ETF industry followed suit, with sponsors developing balanced ETFs to provide turnkey solutions for investors seeking diversified portfolios. From 2007 to the end of 2018, assets in balanced ETFs grew at a compound annual growth rate of more than 47% to $8.7 billion and now represent about 0.26% of the entire ETF industry. While this growth rate has been impressive, assets in balanced ETFs would be 30 times greater (about $260 billion) if they represented the same percentage of total ETF assets as balanced mutual funds do total mutual fund assets.

Types of Balanced Funds

Regardless of whether they come in the form of a mutual fund or an ETF, there are two main types of balanced funds; those that invest directly in equities and bonds and those that invest in other funds to gain exposure to underlying asset classes (the latter of which are referred to as funds of funds).

The earliest balanced funds, which date back to 1929 (three of the nine oldest continuously operating mutual funds in the U.S. are balanced funds[2]), invested directly in stocks and bonds. In the modern era, balanced funds are more likely to be structured as funds of funds. In many cases, fund sponsors limit the holdings in such funds to their own proprietary funds. In other cases, fund sponsors employ an open-access model to create balanced funds offering exposure to funds from multiple fund sponsors.

For investors seeking diversified investment solutions, balanced funds come in three primary strategies:

  • Tactical Asset Allocation Funds are balanced funds that employ active management to adjust their asset allocation based on short-term market forecasts. While research suggests that long-term strategic asset allocations play the most critical role in determining risk-adjusted returns, there is some support for the notion that skillful managers can add value at the margin executing tactical asset allocation strategies. The challenge for investors, however, is ascertaining the level of risk in a tactical asset allocation fund—particularly when an active manager may have the discretion to alter that risk at any given time.
  • Target Date Funds are balanced funds that seek to reduce risk as they approach a target year—usually the year in which investors in the fund plan to retire. To reduce risk, these funds typically decrease exposure to equities and increase exposure to bonds over time on what is referred to as a “glide path.” While target date funds offer a simple solution for investors, they assume that investors of the same age have a similar tolerance for risk, which may not be the case. Moreover, adjusting asset allocations over time makes it more challenging for investors to determine their level of risk.
  • Target Risk Funds are balanced funds that seek to target a level of risk on a constant basis. Morningstar, a mutual fund and ETF research firm, assigns target risk funds to one of five subcategories, ranging from the most conservative (15% to 30% equity) to the most aggressive (85%+ equity). Target risk funds appeal to investors seeking transparency and predictability and are more consistent with modern portfolio theory’s hypothesis that investors should seek to target an optimal portfolio that will earn the highest risk-adjusted returns. The challenge for investors lies in determining which target risk funds can be expected to earn the highest risk-adjusted returns.

The Future of Balanced Funds

While growth in the maturing mutual fund industry will likely continue to slow in the future, balanced mutual funds occupy an enviable position as the default investment option in many company 401K plans. Consequently, asset growth for balanced mutual funds can be expected to outstrip asset growth for the broader mutual fund industry over the next decade and total assets in balanced funds will likely rise to more than 10% of total mutual fund assets over that period.

The ETF side of the industry promises even more asset growth for balanced funds. Market share for balanced ETFs has already grown by a factor of ten since 2007 and yet the category remains a tiny niche—compared to the size of the market for balanced mutual funds. As ETF sponsors place greater emphasis on developing diversified multi-asset solutions and more investors transition to ETFs from mutual funds, the market for balanced ETFs will grow rapidly both in absolute terms and relative to the broader ETF market.

[1] The ICI refers to these types of funds as “hybrid funds.”

[2] The Vanguard Wellington Fund (VWELX), CGM Mutual Fund (LOMMX) and Dodge & Cox Balanced Fund (DODBX) are all balanced funds that have operated continuously since 1929, 1929 and 1931, respectively.