Monday, January 05, 2009



Balanced Funds

Endangered …

Once upon a time, there used to be a type of mutual fund called a 'balanced fund'. It was a very useful type of fund which was generally the most suitable type for a large proportion of retail investors. Actually, balanced funds still exist. It is just that Indian fund houses seem to be trying their best to sweep them under a carpet. If you depend on the marketing and sales efforts of mutual fund houses and distributors to get to know about funds, I am sure that you have not invested a single paisa in a balanced fund. Balanced funds form only approximately 1.5% of the total fund industry assets. Since the stock markets started rising in 2003, 12 new equity-oriented balanced funds have been launched. During the same period, 157 new equity funds have been launched. That is 13 equity funds for every balanced fund. As things stood in 2002, the ratio was 20 balanced funds to 48 equity funds. That is one balanced fund to 2.4 equity funds. Quite a drastic shift…

To figure out why balanced funds need more attention than they get, let us recap what balanced funds (also called hybrid funds) are.

Balanced funds maintain a balance of two types of investments - equity and fixed income. The fixed income part is generally corporate or government debt of various types. These funds are mandated to stick to a fairly well-defined ratio between these two types of assets. This simple structure is more conservative in returns than equity funds but it compensates with some great advantages. Firstly, to maintain the ratio between debt and equity, the fund manager has to periodically sell whichever investment has done better. With the proceeds of the sale, he has to buy the other type of investment to regain the balance. While this sounds counter-intuitive to the average investor, it ensures that the profits from equity are being regularly realised and then protected from vanishing by investing them in safe debt investments. When the equity markets are falling, it ensures that you are buying equities when they are cheap. Invariably, this is the best strategy to combine profits with safety in the long-term. However, individual investors rarely have the discipline to implement it since it is always counter-intuitive to sell whatever is rising and buy whatever is falling.

In the quagmire…..

With the stock market undergoing a sizeable correction since the start of 2008, 30 out of 50 balanced funds in operation now carry a negative return for a one-year period. The ongoing downturn in the stock markets has clearly caught them on the wrong foot. The gap between the worst and the best performing funds in the category is even wider. While the worst performer recorded an NAV erosion of 26 per cent, the best managed a positive return of 22 per cent. In comparison, diversified equity funds turned in returns ranging from a negative 35 to a positive 23 per cent. Close to half the funds trailed equity indices such as the Sensex and Nifty. The downside for the worst performing balanced fund has clearly been lower. As a category, balanced funds did contain downsides better than diversified equity funds.

…..but flavour not so sour

Balanced funds should rightly be the flavour of the season as the equity markets are fraught with volatility and price declines. Balanced funds, with allocations to both stocks and debt instruments, are considered defensive in comparison to diversified equity funds. Balanced funds may opt for differing mixes of debt and equity, with many funds holding a 65 per cent plus equity exposure to gain tax benefits accorded to equity-oriented funds. The allocation to debt by the average balanced fund stands at less than 20%. Most balanced schemes, barring a couple of them, were hardly popular among investors in bullish times because it was felt the debt allocation would hinder maximisation of equity returns. Those schemes, with higher equity allocation to the extent of 80%, were more in demand then. But with the bear phase setting in since January 2008, these funds have been the biggest laggards in the pack, drawing criticism toward equity-oriented balanced funds. Many funds that generated a positive return of 1-7 per cent were children’s schemes, with higher debt allocations. Principal Child Benefit Fund, Magnum Children Benefit Plan and HDFC Children’s Gift Fund Savings Plan are some instances.

Still a safe bet

Over a complete rise-and-fall market cycle, balanced funds invariably produce decent returns with far less volatility and heartburn. Over the last five years, the average equity diversified fund has given returns of about 31 per cent p.a. and the average equity-oriented balanced fund has produced 23 per cent but with lower volatility. Not only does this balanced strategy get stable returns, it is also more tax-efficient than it would be if you executed it yourself. There are two reasons for this. One, every time you would sell you would pay capital gains tax. When funds buy and sell with their portfolio, there is no tax liability to the end-investor. Two, when you hold any kind of fixed income investment yourself, it is liable for long-term capital gains tax since only equity income is exempt from that. However, if a balanced fund keeps its equity allocation above 65 per cent, then the investor's entire investment is treated as equity for tax purposes and thus becomes free from long-term capital gains tax. Best balanced mutual funds keep allocation flexible and open to changes as per the demands of market conditions but subject to regulations by laws of government and SEBI.

… but not extinct

Which brings us to the original puzzle - why then are fund houses and salesmen not enthusiastic about balanced funds? I believe that is because it is difficult to package balanced funds in some kind of a returns-maximising trick story. As the fund industry has gravitated towards consumer-goods type feature-driven products, simple and reliable ideas like balanced funds get side-tracked. But that does not mean that the sensible investor has to ignore them too. There are a handful of excellent balanced funds with solid long-term prospects available (GEM GAZE due to appear next week will help you seek them out).

Wishes… be a winner

2008 was a forgettable year — a sliding stock market and insurmountable inflation for a better part of the year meant a deep dent in savings and investments. Will 2009 be better? The new year is off to a good start….let us hope the winning streak is sustained. Before I take leave, let me wish you all a wealthy and prosperous 2009!

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