STRIKING A BALANCE. How balanced funds help investors gain exposure to upside potential and mitigate downside risk

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1 MFS White Capability Paper Series Focus Month April Author STRIKING A BALANCE How balanced funds help investors gain exposure to upside potential and mitigate downside risk David W. Connelly Director, Global Product IN BRIEF Investors have frequently sold assets in markets about to rise and bought into markets about to fall, in effect allowing emotions to guide short-term decisions at the expense of longer-term investment performance. Combining stocks and bonds in a balanced fund offers investors diversification and the opportunity to achieve improved risk-adjusted performance. The historical performance of a 60% stock and 40% bond portfolio, rebalanced quarterly, demonstrates that investors can take advantage of the outperforming asset class while limiting the impact of the underperforming one. The 60/40 balanced portfolio provides an opportunity for improved riskadjusted performance, capturing 90% of the return delivered by equities with only 64% of the volatility (based on historical performance). Investors have a tendency to be swayed by emotion, often buying at the top of the market and selling when it is at its nadir, with the resulting adverse effect on investment performance. Even savvy investors can be drawn in by the lure of a raging bull market or cowed into submission by plunging stock market returns. When one looks at asset classes individually, volatile swings in performance come into high relief, and the urge to chase good performance and run from weak performance is strong. In this paper, we discuss how taking advantage of the combined performance of multiple asset classes in the form of balanced funds provides the potential for investors to achieve improved risk-adjusted performance. Combining stocks and bonds in one fund can help to mitigate investors propensity to buy high and sell

2 low; therefore, these funds tend to have lower redemption rates relative to single-asset-class funds (see Exhibit 2). These funds also have risk benefits: Balanced portfolios provide exposure to equities along with some down-side risk management strategies and lower volatility than allequity portfolios. A closer look at investor buying habits While the traditional investment adage to buy low, sell high makes intuitive sense, it is often difficult to adhere to when uncertainty is rampant and investors are acting in keeping with their tendency to look in the rearview mirror. The stock market volatility since 2000 and the investment habits of investors illustrate the tendency to buy high and sell low. Exhibit 1 breaks the performance of the S&P 500 Index into periods of generally positive or negative performance and shows the flow of money into equity mutual funds in the prior 12 months of each period. As the period of declining markets was coming to an end and equities were becoming more attractively valued (the period 1/00 to 2/03) more investors were moving out of equity funds than into them (outflows of US$65 billion were recorded), missing the subsequent market rally. Conversely, as the mid-decade market rise was nearing its end and stock prices were peaking (the period 3/03 to 9/07), investors were pouring assets into equity funds, with US$105 billion posted in net inflows. Markets rose substantially in the final period shown, though equities were just barely positive in 2015 when flows turned negative. A balanced approach can help mitigate investors propensity to buy high, sell low As shown in Exhibit 1, it is usually detrimental for investors to move in and out of asset classes in response to recent market returns. Investors are generally better served by engaging in persistence, i.e., remaining invested through a full market cycle. While we are unable to compare holding periods directly, Exhibit 2 compares mutual fund redemption rates by broad asset class groupings. Redemption rates can be used to make inferences, at least directionally, about the relative intensity of trading activity seen in different investment products. This provides an indication of which types of products might be less prone to market timing. Based on five-year rolling redemption rate data from the Investment Company Institute (ICI), hybrid funds, including balanced and other multi-asset strategies, exhibited the lowest redemption rates of the five fund types monitored by ICI. Exhibit 2: Average rolling 12-month redemption rates for the five years ended December % 26.9% 25.7% 22.7% 29.4% Exhibit 1: Investors unsuccessful at timing stock market shifts Investors moved assets out of the stock market when it was bottoming and into stocks when they were close to their peaks. Time period Market environment S&P 500 cumulative return Equity fund flows last 12 months of each period 1/00 to 2/03 Falling % -$65 billion 3/03 to 9/07 Rising 97.21% $105 billion 10/07 to 2/09 Falling % -$190 billion US equity World equity Hybrid (balanced) Municipal bonds Taxable bonds The average redemption rate is the average of five years of rolling 12-month redemption totals expressed as a percentage of the average AUM for that same period and includes both redemption and exchange figures from the ICI Trends report. Source: Investment Company Institute (ICI). 3/09 to 12/15 Rising % -$77 billion Sources: SPAR, FactSet Research Systems Inc., ICI/Strategic Insight. 2

3 Exhibit 3: Bridging the performance gap between stocks and bonds Calendar-year performance differential relative to a quarterly rebalanced 60% stock/40% bond portfolio. -30% -20% -10% 0% 10% 20% 30% 100% BONDS 60% STOCKS 40% BONDS % -20% -10% 0% 10% 20% 30% Stocks as represented by the S&P 500 Index, which measures the broad US stock market. Bonds as represented by the Barclays U.S. Aggregate Bond Index, which measures the US bond market. Source: SPAR, FactSet Research Systems Inc. Please note that the outperformance of 60/40 portfolio in 1987 to both stocks and bonds was the result of quarterly rebalancing. The start of the period coincides with the inception of the Barclays U.S. Aggregate Bond Index. It is not possible to invest directly in an index. Past performance is no guarantee of future results. 100% STOCKS 3

4 The lower redemption rates of hybrid/balanced funds imply that investors hold these funds relatively longer than they do other types of products. MFS believes investors in balanced funds are likely to gain comfort from the diversification benefits they provide, counteracting the natural instinct to bet on the direction of the market and move in and out of different asset classes. Balanced funds can help moderate the volatility of stocks and bonds Over the long term, equities have delivered greater returns than bonds, compensating investors for taking on the relatively higher risk of equity investments. Over the past 40 years, stocks, as measured by the S&P 500, have delivered an average annualized return of 11.35%, while bonds, as measured by the Barclays U.S. Aggregate Bond Index, have delivered average annual returns of 7.67%. However, as investors are acutely aware, shorter-term equity returns are more volatile than those of fixed-income securities. Additionally, if we look at calendar-year returns, we see that the performance relationship between the two asset classes is highly variable. Over the past 40 calendar years, stocks have outperformed more frequently (28 times) by an average of 12.68% over bonds in those years. Bonds have outperformed less frequently (11 times), but by a more significant average differential in those years, of 16.02%. A proven, straightforward approach to accessing the longterm excess returns equities provide, while moderating their volatility is to combine stocks and bonds in a balanced portfolio. The historical performance of a traditional 60% stock and 40% bond portfolio, rebalanced quarterly, illustrates how a multi-asset-class fund has cushioned market peaks and valleys for investors. Exhibit 3 shows calendar-year returns for stocks, bonds and a 60% stock/40% bond mix. The graph displays the calendaryear return differential of both stocks and bonds relative to the 60/40 mix. While the year-to-year performance relationship between stocks and bonds has often shifted dramatically, a 60/40 mix has typically landed somewhere in between by providing participation in the outperforming asset class while limiting the impact of the underperforming one. Although investors can get the same exposure by holding stock and bond funds separately, a balanced fund that combines asset classes can help investors combat the natural urge to chase the outperforming asset class and abandon the underperforming one. Negative equity returns are mitigated with a multi asset class approach As we have observed in the last decade or so, short-term negative returns cause investors to lose resolve and abandon longer-term investment strategy. In fact, investors often focus on avoiding short-term losses at the expense of longer-term investment objectives, a behavior called myopic loss aversion within behavioral finance circles. Exhibit 4: How bad was it? Not as bad with a balanced approach. A 60/40 mix cushioned the degree and frequency of losses. Rolling 12-month periods from January 1976 to December S&P 500 Index 60% S&P 500 Index / 40% Barclays U.S. Aggregate Bond Index Negative return Loss more than 5% Loss more than 10% Loss more than 25% 1 10 Out of 469 total periods Start of period coincides with inception of Barclays U.S. Aggregate Bond Index. Source: SPAR, FactSet Research Systems Inc. 4

5 A balanced portfolio has historically moderated the degree and frequency of losses an investor experiences relative to an all-equity portfolio. Exhibit 4 illustrates how a balanced portfolio lessened the number of occurrences of more pronounced losses. MFS believes this historical moderation of downside risk can help investors maintain discipline during volatile markets. The whole is greater than the sum of its parts We previously looked at the long-term annualized returns of stocks and bonds. Let s look now at the historical tradeoff of returns and risks offered by stocks, bonds and a quarterly rebalanced 60/40 mix. A common measure of the volatility of returns, or risk, of different portfolios is standard deviation. A lower standard deviation indicates less return volatility. Exhibit 5 plots the long-term annualized returns and standard deviations of bonds and stocks and shows how the longterm outperformance of stocks has been accompanied by greater return volatility. Exhibit 5: Risk/Return profile for stocks, bonds and a 60/40 mix A balanced portfolio has historically offered an attractive risk/reward profile. January 1976 December ANNUALIZED RETURN 13% 12% 11% 10% 9% 60/40 Risk 9.65 / Return 10.21% Stocks Risk / Return 11.35% One might expect that a portfolio that combines stocks and bonds would have a risk/reward profile that falls somewhere between the two asset classes. However, because the returns of stocks and bonds are not perfectly correlated, there are diversification benefits from combining the asset classes, resulting in an improved risk/return profile for a 60/40 mix. In fact, historically the balanced portfolio captured 90% of the return delivered by equities with only 64% of the volatility. 1 Conclusions The tendency of investors to be influenced by volatile shifts in the markets is unlikely to change. However, a portfolio of 60% stocks and 40% bonds rebalanced quarterly has historically helped bridge the significant periodic performance gaps between stocks and bonds moderated the downside risk and volatility associated with an all-equity portfolio delivered greater long-term returns than an all-bond portfolio offered the opportunity for improved risk-adjusted performance MFS believes the structure of this approach with the associated diversification benefits can help investors address the inherent uncertainty in the market and the natural human tendency for emotions to drive investment decisions often to the investor s detriment. 8% Bonds Risk 5.42 / Return 7.67% 7% ANNUALIZED STANDARD DEVIATION (RISK) The start of the period coincides with the inception of Barclays U.S. Aggregate Bond Index. Stocks (represented by S&P 500 Index). Bonds (represented by Barclays U.S. Aggregate Bond Index). Source: SPAR, FactSet Research Systems Inc. Standard deviation is an indicator of the portfolio s total return volatility, which is based on a minimum of 36 monthly returns. The larger the portfolio s standard deviation, the greater the portfolio s volatility. Past performance is no guarantee of future results. 1 For the time period Jan to Dec

6 Keep in mind that all investments, including mutual funds, carry a certain amount of risk, including the possible loss of the principal amount invested. No investment strategy can guarantee a profit or protect against a loss. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in debt instruments may decline in value as the result of declines in the credit quality of the issuer, borrower, counterparty, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall), therefore the Fund s share price may decline during rising rate environments as the underlying debt instruments in the portfolio adjust to the rise in rates. Funds that consist of debt instruments with longer durations are generally more sensitive to a rise in interest rates than those with shorter durations. At times, and particularly during periods of market turmoil, all or a large portion of segments of the market may not have an active trading market. As a result, it may be difficult to value these investments and it may not be possible to sell a particular investment or type of investment at any particular time or at an acceptable price. The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. Before investing, consider the fund s investment objectives, risks, charges, and expenses. For a prospectus or summary prospectus containing this and other information, contact MFS or view online at mfs.com. Please read it carefully. MFS Fund Distributors, Inc. MFSE-BAL-WP-4/