FUND FLAVOUR

January 2017

Balanced Funds strive towards perfection

The perpetual question that investors are faced with is: Debt or Equities. As an investor, should you opt for volatility and get high returns of equities? Or should you seek safety in debt while gathering moderate returns? While it is agreed both have their pros and cons, making this choice is difficult because we are always trying to get the best of both the worlds. What if there was a way to invest in both - equities and debts and generate high returns with moderate risk? That sounds like perfection and that is what balanced funds strive to be.

Raison d’etre

There is no shortage of self-proclaimed investing experts trying to outperform the market with equity mutual funds. Debt mutual funds, on the other hand, occupy a slightly more humble, yet potentially rewarding, spot on the spectrum. Your need for each asset class, as an investor, depends on your age and goals, rather than market conditions.

That is where balanced funds come in.

Balanced funds combine different asset classes, such as equities and debt, to help investors leverage the high returns from equities over time while also benefitting from the steadier, but lower returns from debt.

It all comes down to that age-old maxim, “no risk, no reward.”

Equities are high-risk investments due to their exposure to corporate performance, so the possibility of higher returns is the upside you get for taking a bet on companies. There is also a chance one bad day on the stock market could wipe out your entire investment. It could take months or years to recoup that money.

The downside of debt funds is that the returns are lower because they invest in fixed income bearing instruments like corporate bonds, debentures, government securities, commercial paper, and other money market instruments. But the chance of default will be rare if the issuer to whom you are technically lending the money (the government or a corporation) has a high credit rating. However, the relationship between bonds and interest rates may also affect returns positively or negatively.

So, asset management companies designed balanced funds to provide investors with a moderate-risk product. Left on their own, equity and debt will bring you either too much volatility or too little returns. Balanced funds allow for diversification so you can benefit from the best of both worlds without putting all your assets on the line.

Because balanced funds comprise different equity and debt components, they can be classified as “aggressive” or “conservative” funds, with varying degrees of capital protection, growth, and income.

Equity-oriented balanced funds (minimum 65% in equity) earn returns that are generally lower than a purely equity-focused fund, but again, the risk is also lower. The equity component of balanced funds can veer toward higher-risk sector-specific or small-cap companies, or can comprise safer investments such as blue-chip stocks. Debt-oriented balanced funds contain more debt (70-85%) than equity. The risk level would be higher than that of a pure debt fund, but lower than an equity-oriented balanced fund because of a smaller equity component. Debt funds known as monthly income plans also allow conservative investors to earn a regular dividend.

If the value of equities in a balanced fund drops or rises due to market conditions, the manager (a balanced fund may have more than one person supervising it) has to adjust the weightage by buying or selling more shares proportionately to maintain the ratio of equities to debt.

It is important to remember that, while equity and debt markets tend to be inversely related, they have at times gone either way at once. And while debt is generally a safer investment than equities, interest rate movement and the risk of default will always, in theory, be a risk.

Ultimately, the decision to invest in a balanced fund depends on your risk tolerance, time-frame and objectives. Remember that balanced funds are not the only way to mix up your investment strategy – you can also diversify by allocating your resources into separate pure income funds or pure equity funds.

Conflict and confusion

The first conflict that you may have in mind is instead of investing in one scheme and putting all eggs in one basket, it is probably better to invest individually in equity schemes and debt schemes. One of the myths concerning balanced funds is regarding the usage of the word ‘balanced’ and the confusion it tends to create. Investors are often under the illusion that the word balance connotes a 50:50 investment in debt and equities. This could be far from the truth. The word ‘balance’ is used to denote that equities pose a certain risk to investments due to volatility of stock markets. Hence, to balance out the risk a certain percentage of debt investments are made.

Advantage balanced funds

Let us have a look at the factors that make balanced funds the best bet.

Reduces the need to diversify

Diversification is one aspect you have probably heard experts talk about when they discuss ‘successful ways of building a portfolio’. You are constantly thinking of ways to rebalance and diversify and moving around your funds and not allowing your investments to settle at one place. Investing in balanced funds reduces the need to constantly move around funds as it auto rebalances the allocation.

Asset Allocation has been done

Getting the asset allocation right is the biggest challenge for any investor. People spend years in the industry and still fail to be sure if the asset allocation will yield the right results as it has often been on a slippery ground. In balanced funds, the asset allocation is carried out depending on the fund’s inclination to debts or equities. One of the major factors taken into consideration during asset allocation is the current age of the investor. The thumb rule states that “100 minus the age of the investor” will determine the percentage in equities.

In case of a balanced fund, the investors just have to make a choice between equity-oriented balanced funds and debt-oriented balanced funds. So, if an investor is 40 years old, then it is advisable to invest 60% (100-40=60) in equities and 40% in debts or instead invest in equity-oriented balanced funds. In another case, if an investor is 60 years old, then it is advisable to invest 40% (60-100=40) in equities and 60% in debts or instead invest in debt-oriented balanced funds. The existence of balanced funds does make the process of asset allocation fairly simple for investors.

While balanced funds rebalance the risk, the return difference between pure diversified equity mutual funds and equity-oriented balanced funds is very less. Investors can still make good returns from equity-oriented balanced funds by not taking as much risk as they would have taken in case of diversified equity funds.

The tax benefit angle

Balanced funds, from a tax perspective are treated like equity funds, because these funds have at least 65% of their portfolio invested in equities. Like equity funds, capital gains from investment in balanced funds held for over 12 months is tax free. Capital gains from investment in debt funds held for a period of less than 36 months is added to the income of the investor and taxed as per the investor’s tax rate. Capital gains from investment in debt funds held for over 36 months is taxed at 20% with indexation benefits. Therefore, purely from a capital gains tax standpoint, investment in balanced fund is more efficient than investment in a combination of equity and debt fund.

Promises returns and safety

It would be an ideal scenario if an investor could maximise returns by undertaking zero risk. While ideal scenario is hardly achievable in reality, investing in balanced funds brings us closer to that. The balanced fund balances out the risk imposed by equities by investing in debt, thus making this a moderately safe investment. Investors with varying risk appetites can invest in these funds without the fear of making loss.

It is often believed that one should not invest in funds based on future predicted performances. It is also said that past performances or stellar performances on paper are no guarantee for the future return. However, advisors and experts often rely on the stability of the past performance of the funds. The sudden rise or drop in performances is never appreciated as it points towards volatility and the investors must try to avoid it. In the last ten years the funds have delivered decent returns and in some cases stellar returns. None of the funds have depreciated despite dwindling markets in most parts of the last decade. Equity-oriented balanced funds have given a stellar performance and generated cumulative returns of over 270%.

The flip side

Asset allocation is often considered to be a personalised task where investors and advisors discuss and design a portfolio which is especially suited to the investor’s need. While balanced funds have asset allocation inbuilt in the funds they are not customised to fit into the individual investor’s needs. The changes in asset allocation take place only when there are drastic changes in the market. Otherwise, the asset allocation remains fixed despite the changes in investor’s need. Hence, these funds are not tailor-made. They cater to a larger objective and not to personalised objectives or needs. So, an investor has to make an investment decision to design a portfolio with asset allocation which will generate the stellar returns as the funds or invest in balanced funds.

The rising popularity

Though balanced mutual funds have been around for quite some time investors have recently warmed up to them. Data from ValueResearchOnline show that investors pumped in Rs 28,484 crore into balanced funds in financial year 2016, compared to Rs. 15, 417 crore in financial year 2015, a whopping 84% increase. According to a recent report, balanced funds raked in Rs 3275 crore in October 2016, higher than the Rs 3,248 crore that went to equity funds. With rise in the popularity of balanced funds, the fund houses have seen growing competition. Balanced mutual funds have witnessed inflows to the tune of Rs 2,079 crore in the month of July 2016, alone. Thus, with rising inflows and improved performances of markets, balanced mutual funds are increasingly offering dividend payouts. New investors often do not realise that dividends are paid out from capital investments and not over and above the invested amount. For example, if you hold 100 units of a mutual fund and it offers a dividend of Rs 5 per unit, you may receive Rs. 500 as dividend payout every month but the NAV of your investment is adjusted proportionally.

Checklist prior to investment

Check on the equity and debt investment component of the balanced fund before making an investment call. An equity-oriented fund would have at least 65% exposure to equity.
Compare the expense ratio of the funds, which amounts to administrative, management, and advertisement costs. Opt for the one which has a low expense ratio and a good performance record.

Check on the risk level and fund ratings along with the performance and experience of the fund manager. Since balanced mutual funds have a large exposure to the equity market, you do not want to leave your funds in an amateur’s hands.

Balanced funds are excellent option for investing for the long term. Balanced funds make a good investment choice even in a falling market as the fixed returns on debt keep the returns steady. Therefore, investors with the help of the debt component often get ahead of falling markets. The investors again can take advantage of rising markets due to the exposure in equities. Hence, investors can gain much more than they have to lose by investing in balanced funds. In fact, balanced funds should be the core investment element in a mutual fund portfolio of first time investors. With automatic rebalancing of your portfolio and tax efficient returns, equity-oriented balanced fund could be one of your best investing choices if you are able to take moderate risk. However, if you are a conservative investor then you can consider debt-oriented balanced funds like Monthly Income Plans (MIP), etc. So, instead of pouring hours over different funds and schemes and figuring the right asset allocation and the ways to rebalance go for the balanced fund option and see your investments grow steadily.