Monday, January 06, 2014


January 2014

We have been prodded by nutritionists to eat a balanced diet. We have been told by numerous groups that a key to workplace success is a work-life balance. Individuals weigh choices on a daily basis in an effort to determine what might be good or better for us than the alternative. Finding the right balance is no easy feat.

What is balance in investing?

The answer varies from investor to investor. What you own in your portfolio and are comfortable with might be wholly different from that of the person sitting next to you at work. Who you are impacts your individual balance, the clear line that determines how well you sleep with the investment choices you have made. Knowing that you might not have a clear indication of your own balance, mutual funds suggest an investment that can give you a sort of asset allocation opportunity that you may not have been able to accomplish on your own. Balance in investing suggests diversity using both equity and debt portfolio to both grow and protect your money.

A balanced fund…

Balanced funds are hybrid mutual funds that invest in equity and debt instruments, and usually balanced equity funds invest no more than 35% of their money in debt instruments. With debt markets turning volatile after a steady run over the past year, investors are in a dilemma over their allocation in key asset classes, viz., equity and debt. Balanced mutual funds offer a simple solution to this dilemma as they invest 65-80% into equity and the balance in debt instruments. Equity has the potential to deliver superior long term returns while debt provides stability to the portfolio. This diversification protects the portfolio from downside risks if either equity or debt enters a bearish phase. It is important for investors to look at an asset allocation approach; however the way it is executed is also equally important. Investors often tend to re-allocate assets based on market sentiments which may not be in their best interest. In comparison, balanced funds follow a well-defined asset allocation approach that offers a higher degree of protection on the downside but preserves much of the upside thereby serving investors well.

The rationale…

The main reason for investing in a balanced fund is to take advantage of the asset allocation strategy; as mentioned above, by having the debt portion cushion the fund during down markets, while also participating in the rally in equities when investor risk appetite returns. One interesting finding published by the fund research firm Morningstar in the United States shows that while equity funds outperform balanced funds in bull markets, investors holding equity funds may not actually be able to enjoy the gains fully. Morningstar explains that this is because equity fund holders might execute poorly timed trades that tend to erode their gains. Conversely, balanced fund investors who are more likely to stay invested even during market downturns experience returns much closer to what the performance numbers suggest.

On the flip side…

Of course, there is downside to balanced fund investing. First of all, fund factsheet of a balanced fund usually does not disclose separately the performance of the equity and debt components of the portfolio. As such, one is not sure about the individual performance of the equity and debt portions.

In case you have invested the entire amount in balanced funds and you need some money for your emergency need, you have no other choice but to redeem from balanced funds. Therefore, for every redemption of Rs 100 you are actually redeeming Rs 65 from equity and Rs 32 from debt. Even if you are a long term investor in equity, your equity gets redeemed automatically.

Besides, balanced funds usually have target asset allocation between equities and debt (minimum 65% in equity). Fund managers have limited freedom as 65% is the minimum requirement to take the benefit of taxation. However, investors may have different risk appetites and needs. A balanced fund may be too rigid for an investor who has a flexible risk appetite that depends on current market conditions. As such, investors may need to include other pure debt or equity funds in their portfolio to achieve the optimal target allocation. The choices are limited. This essentially requires investors to construct their own portfolio and make the balanced fund redundant.

Standing the test of time…

CRISIL's study reveals that balanced funds (measured by the CRISIL – AMFI Balanced Fund Performance Index) have outperformed the CNX Nifty (equity markets) across 3, 5, 7 and 10 year timeframes. Balanced funds also witnessed lower capital erosion when equity markets declined and enabled investors to capitalize from gains in equity markets by delivering returns higher or similar to those of the CNX Nifty (equity markets). Balanced funds were also less volatile (a measure of risk) with 17% annualised volatility over a 5-year period compared to almost 25% for the CNX Nifty.

The CRISIL-AMFI balanced fund index declined 35.9% during the subprime crisis between January 2008 and March 2009. The Nifty fell 43.4% during the period. Similarly, they gained at a faster pace during the bounce-back that followed the sub-prime crisis. Balanced funds surged 51.7% between April 2009 and December 2010 compared to the 48.8% gains made by the Nifty. These funds have also managed to hold their ground when markets started their losing streak in the aftermath of the crisis in Euro-zone countries. Balanced funds managed to stay in the green during the period.

There are altogether 21 balanced mutual fund schemes available in the market today. All of them are benchmarked against the CRISIL Balanced Fund Index. Of the 21 balanced schemes, as many as 15 managed to beat the benchmark. The benchmark itself has yielded 16.35% returns till date. Overall, balanced funds have performed quite well. Many of them have been riding high on the robust performance of equities during the period. However, the real worth of a balanced fund is tested in tough times. So, if and when the market declines, taking down equity-heavy mutual funds with it, a balanced fund will have delivered on its objective if it succeeds in protecting your investments.

Helping you avoid mistakes

A research-documented reason to like balanced funds: They help you to avoid common behavior that leads to investing mistakes. To appreciate the evidence for this, you first need to understand the concept of investor returns as distinguished from fund returns. We are all familiar with the annual returns that mutual funds report in their glossy ads. But investor returns are what the average investor actually earns from the fund. Why would those numbers be different? Consider a fund that has a great quarter and goes up 5% early in the year. That is approximately a 20% annual return. Investors see that great return and pile in. Then the fund flat lines for the rest of the year. So it winds up the year by earning 5%, while most of its investors earned nothing. That is investor returns.
In 2011 Morningstar completed a study on the gap in investor returns — how individual investors do compared to their funds’ overall returns. Here is a snapshot of what they found: In 2010, the average domestic stock fund earned a return of 18.7% compared with only 16.7% for the average fund investor — a 2% difference. For the trailing three years, that gap was 1.28%. However it was a different story for balanced funds: The gap between investor and fund performance in 2010 was only 0.14%, and just 0.08% for the trailing three years. Results were even better for the trailing 10 years. And results were similar for target-date funds and moderate- and conservative-allocation funds — close kin to balanced funds. As anybody who has crunched retirement numbers knows, a 1-2% difference in annual return over long periods can easily add up to tens of thousands of rupees!

Why do individual investors do better when they are buying and holding balanced funds? It is probably because balanced funds do not tend to incite fear or greed — two emotions that can be lethal to investment performance. Balanced funds are easier to live with. It’s like the difference between a family sedan and a race car. The race car might have awesome performance, in the right hands. But, for those of us who aren’t full-time professional drivers, there are much better vehicles for driving around a city. It’s the same with investing: For most people, a vehicle with predictable behavior, that they can handle, will produce better results. Use balanced funds to start out investing. They are the best of both worlds.

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