When the overall markets sink during times of financial crisis, many investors can lose their shirts. There are a few funds, however, which are constituted to provide enough balance so that they don’t lose too much even in the most challenging times. These “all-weather funds" have weathered a number of serious financial storms, managing to save the day for their investors. Here's a look at how all-weather funds work, their underlying concepts, and some top funds that have performed well during the past decade's most turbulent times.
What's an All-Weather Fund?
An all-weather fund is a type of mutual fund which performs well (or at least is expected to) in all kinds of market conditions. Irrespective of whether the market is up or down, these funds tend to retain their valuations at an appropriate level. They may not necessarily guarantee capital protection, but they'll aim to prevent losses on the downside to a large extent. All-weather fund managers' strategies include the use of uncorrelated diversification and hedging. (See related: How To Create Capital Protected Investment Using Options.)
How Do All-Weather Funds Work?
Markets typically move based on changes in the conditions responsible for the pricing of a security. For example, a bank stock trading at $32 per share may stay around this price level during a stable interest-rate period, with a substantial change happening only due to the bank's own intrinsic value appreciation. So if the bank decides to expand by opening 100 branches in a new geographic area, its valuation could increase based on a generally-anticipated rise in new business.
However, any change in interest rates by regulators or spikes in inflation could have a negative effect on these banking stocks' valuations. While these external factors may not have anything to do with the bank’s intrinsic business, it doesn't really matter. Even if the bank stock's being punished for factors out of its control, its business is still affected. Shifts in market conditions lead to changes in pricing of securities, making them vulnerable to devaluation.
By studying changing market conditions and their impact on financial securities, all-weather funds attempt to appropriately proportion their holdings so that their overall portfolio remains shielded to a good extent. Their challenge is to build an investment portfolio that performs well across all economic environments, whether it's a recession, a sporadic large dip in the overall market, a change in geo-political situations or something completely unexpected.
The concept of all-weather funds is based on the following assumptions:
1) Future asset prices are difficult to predict with accuracy;
2) There are typically four economic scenarios - rising growth, falling growth, rising inflation and falling inflation; and
3) Different securities and asset classes react in predictable ways to the changes in the above-mentioned economic scenarios.
So rising growth is usually accompanied by the stock market touching new highs and interest rates being lower, which offers easy access to capital for many businesses. Falling growth typically creates a reverse scenario. Periods of rising and falling inflation tend to produce changes in interest rates, although the U.S. has had very stable inflation rates over the last two decades.
By having a good working knowledge of these various dependencies, all-weather funds arrange a suitable selection of assets in balanced proportions. The goal is to create a portfolio which remains protected and stable, regardless of whichever economic scenario is currently underway.
Example of All-Weather Funds
The simplest example of an all-weather fund is a balanced fund that offers a 60%-40% mix of stocks and bonds. So in the case of rising growth, the 60% stock composition should likely improve in valuation, while the 40% bond composition may remain stagnant or even dip. The reverse will typically occur during a period of falling growth. Periods of rising inflation often result in higher interest rates and possibly lower returns on stocks, so here the funds' bond holdings will tend to pick up the slack, performance-wise. And again, the reverse situation often occurs during periods of falling inflation, where stocks may prosper while bonds underperform.
Beyond the basics of a diversified 60-40 stock-bond mix, all-weather fund managers employ a number of more specialized strategies. These include using derivatives for hedging to prevent downside, diversification into alternate investments like real estate, mortgage-backed securities, private equity and commodities, and diversification at international levels.
Due to their highly-diversified constitutions, categorizing all-weather funds is somewhat difficult. Even the simple 60-40 fund is more popularly known as a balanced fund or a hybrid fund, even though it fits the all-weather category.
Top All-Weather Funds
Let’s look at a few popular all-weather funds which have performed well during some economically turbulent times:
- Manning & Napier Pro-Blend Cnsrv Term S Fund (EXDAX): With a total expense ratio of 0.89%, the EXDAX aims to protect capital while generating income and seeking growth opportunities as secondary priorities. It invests primarily in U.S. bonds, corporate bonds, junk bonds, U.S. and global stocks, derivative and REIT instruments. (See related: Bond Basics: Different Types Of Bonds.)
- Vanguard Wellesley Income Inv Fund (VWINX): The fund invests two-thirds of its capital in corporates, Treasuries, government agency bonds and mortgage-backed securities. The remaining one-third is placed in high dividend-paying securities. The fund aims for long-term growth of income with a regular dividend payout, along with moderate long-term capital appreciation.
- Berwyn Income Fund (BERIX): The Berwyn Income Fund aims to achieve long-term capital appreciation, with current income as a secondary consideration. It has a relatively high expense ratio of 1.17%. Around 80% of its investments are in equities which have potential for price appreciation, while 20% are in bonds. Its strategies involve identifying securities which are undervalued. It uses fundamental analysis with macroeconomic factors like inflation, price-to-earnings (P/E) ratios, interest rates, stock market psychology and political factors.
- PIMCO All Asset All Authority A Fund (PAUAX): This is a fund of funds, which invests in shares of underlying PIMCO Funds and does not invest directly in stocks or bonds. These funds include short-strategy funds, local U.S. and international equity funds and inflation-related securities. The fund aims for maximum real return, consistent with preservation of real capital and prudent investment management.
- Westwood Income Opportunity Instl (WHGIX): The fund aims to to provide current income, while looking for long term capital appreciation as a secondary objective. Almost 80% of its capital is invested in dividend-paying and/or interest-bearing securities, while the remaining 20% may include REITs, ADRs and ETFs. It has a low expense ratio of 0.86%.
- Permanent Portfolio Fund (PRPFX): A highly-diversified fund, it invests in a wide range of securities that include gold, silver, Swiss franc assets, real estate and natural resource company stocks, aggressive growth stocks and dollar assets.
Let's see how these all-weather funds have performed during different periods of market turbulence.
Periods of Declining Stock Market Returns
Our periods of study examines when the S&P 500, the world’s most-followed stock market indicator, dropped more than 10% during these given periods:
- Aug. 8, 2008 – Oct. 10, 2008: The start of global financial crisis of 2008-09.
- Jan. 2, 2009 – Mar. 6, 2009.
- Apr. 23, 2010 –July 2, 2010.
- July 22, 2011– Aug .19, 2011.
- Apr. 27, 2012 – June 1, 2012.
- Sept. 14, 2012 – Nov. 16. 2012.
- Aug. 17, 2015 – Sept. 1, 2015: Recent Chinese meltdown.
Below is a comparison of the returns of the S&P 500 index with those of the above-mentioned all-weather funds, during the first period mentioned: mid-2008, when the global financial crisis started:
The above chart indicates a comparatively better performance for these funds. While the S&P 500 fell around 31% between August-October 2008, all of these funds managed to keep their downside to a range between -7.7% and -13%. Even on Sept. 17, 2008, when the S&P 500 index was down by -10.8%, the best performing fund, EXDAX, managed to stay afloat, with only a -0.25% decline.
While providing detailed charts for all of the above-mentioned periods is out of the scope of this article, examining a similar chart for all of mentioned periods will show that these all-weather funds performed better than the S&P 500 index in each case.
Periods of Declining Interest Rates
U.S. interest rates have consistently fallen over the last 20 years. The performance of 10-year Treasury bond interest rates and the six all-weather funds we mentioned are compared in the following chart. Despite a consistent decline in interest rates over the last 10 years, all funds (expect for PAUAX) have maintained positive returns. (Image courtesy Yahoo! Finance.)
The above chart is a testament to the consistent performance of these all-weather funds. The only negative dip that they experienced was during late-2008 early-2009, when the global markets crashed. And even during that time fund returns were better compared to those of key stock market indexes (as indicated in the earlier section)
As indicated by the consumer price index and wholesale price index, inflation has remained steady in the U.S., which has had neither significantly high inflation in the last decade nor shown any signs of deflation. As the above graph shows, the 10-year performance of the six all-weather funds indicates that these funds also maintained a steady performance despite these factors.
The Bottom Line
Whether it's via bonds, stocks, commodities, funds, derivatives or alternate investments, what matters most for investors is to achieve the highest possible returns for an acceptable level of risk. All-weather funds have provided a steady safe haven for many investors, as can be seen from some historical observations. These funds can add a balanced proportion to an investor's portfolio and can help to provide protection against downside. (Further suggested reading: 8 Fund Types To Use In A Recession.)
Disclaimer: The author does not hold any positions in the aforementioned funds.