FUND FLAVOUR

January 2020

Balanced Funds…

Balanced or hybrid mutual funds are a one-stop investment option offering exposure to both equity and debt segments. The main intention of hybrid funds is to balance the ratio of risk-reward and optimising the return on investment. Top hybrid mutual funds invest about 50% to 70% of the portfolio in equities and the rest in debt instruments. Hybrid funds or balanced funds entail the combination of equity and debt in a single mutual fund portfolio. Hybrid funds come in different combinations of equity and debt. Equity and debt funds represent two extremes of the investment spectrum. The actual needs of investors lie somewhere in between. The answer in most cases is to buy equity and debt funds in the required proportion. But that is easier said than done. It calls for retail investors to understand and evaluate equity funds and debt funds in detail so as to make an informed decision. A mid-way solution could be the Hybrid Funds. These funds combine equity and debt either in pre-determined proportions or in dynamic proportions and then offer it as a readymade product for the investors. As an investor you have a wide choice before you with hybrid funds.

The classes…

There are two ways of classifying the hybrid funds. Hybrid funds can either be classified on the basis of the asset mix or on the basis of the discretion available to the fund manager. 

Let us first look at hybrid fund categories from the point of view of the asset mix.

• ·      Hybrid funds that are predominantly equity Hybrids. These funds invest more than 65% of their asset allocation in equities and the balance in debt. This ratio can vary but typically, the fund manager will not allow the equity proportion to go below the 65% mark. That is because, 65% exposure to equity is the bare minimum requirement for a fund to be classified as an equity fund for tax purposes. Once a hybrid fund is classified as an equity fund due to exposure to equity above 65%, then dividends and capital gains are taxed at a concessional rate. That substantially improves the post-tax yields.

• ·         Debt Hybrids like a Monthly Income Plan (MIP) is a classic example. Here the predominant exposure is in debt. So an MIP will have around 75-80% in quality debt paper and the balance will be invested in equities. For tax purposes, the MIP will be classified as a non-equity fund but the small equity exposure enables the company to earn Alpha. Being predominantly debt oriented, the MIPs are also very useful for retirees who can afford to take slightly higher risk on their investments for higher returns.

• ·         Hybrid funds can also be in the form of arbitrage funds. In arbitrage funds, the fund manager buys a portfolio of equities and sells equivalent futures against that. The spread is the profit and it is like earning interest. The returns on these arbitrage funds vary from 6-8% per annum depending on the spreads in the market. Since futures are leveraged products, these funds are classified as equity funds due to predominant exposure in equities and get preferential tax treatment. This makes them more attractive compared to other fixed income instruments.

Hybrid funds can also be classified based on the discretion to the fund manager on asset allocation.

• ·      Hybrid funds or balanced funds can be static allocation funds where the mix between equity and debt is broadly fixed in a range. The fund manager normally does not go outside these limits. These are the most common type of hybrid funds in India.
• ·       There are also dynamic allocation hybrid funds where the equity/debt mix can widely be changed. It can even move from a predominantly equity to predominantly debt fund and vice versa. Such shifts are either based on the discretion and outlook of the fund manager or based on lifestyle goals. That is why dynamic allocation plans are quite popular when it comes to long term planning like retirement, children’s education etc.

As per the SEBI new norms on re-categorization of mutual funds, there are 7 categories of hybrid funds.

• Conservative hybrid – these schemes invest around 75-90% of total assets in debt instruments and 10-25% in equity instruments
• Balanced hybrid – These schemes cannot invest in any arbitrage fund and mostly invests around 50-60% in either debt/equity related instruments
• Aggressive hybrid – The composition of these funds includes investments of around 65-85% of total assets in equity related instruments and the remaining in debt instruments.
• Dynamic asset Allocation – these are also known as balanced advantage funds. As the name says, the composition of investments in debt and equity instruments varies dynamically.
• Multi asset allocation – Invests in at least three asset classes with a minimum allocation of at least 10% each in all three asset classes
• Arbitrage funds – These schemes as the name suggests follows arbitrage strategy and invests at least 65% of total assets in equity related instruments.
• Equity savings funds – Open ended scheme investing in equity – minimum 65% of total assets, debt – minimum 10% of the total assets. They also mention about the least hedged and unhedged investments in the scheme information document.

The pros…

Best of Both Worlds - Balanced funds are suitable for investors who want to enjoy the returns from equity investments but with a safety cushion. Normally this is true for first time investors or investors who have low to moderate risk appetite. Since balanced funds are a mix of equity and debt, they have lower volatility than the equity funds and their returns are higher than the debt funds. Though in a bull market these funds will not give you as much return as pure equity funds the loss would be lower than those funds in a downward moving market.

Diversifying Portfolio - Balanced funds allow investors to diversify their portfolio as they invest in a variety of instruments like equities and bonds.

Re-balancing- Sometimes equity markets are overvalued relative to debt markets and vice versa. In such a situation, the fund manager should be given the freedom to move between the two asset classes. This leeway is given in balanced mutual funds.

Risk factor is negotiable - You can determine the amount of risk you want to bear in case of hybrid funds. Risk takers can opt for the best hybrid mutual fund, which is equity-oriented. On the other hand, people who require stability are best suited for debt-oriented mutual funds.

Yield Good Returns - Balanced funds will yield sizeable returns owing to the fact that they invest a major portion in equities.

Stability of Returns - The main reason behind creation of these funds is to provide stability to investors. While equity poses a high risk on the total investment due to unstable dividends, debt instruments help compensate for it by providing steady returns.

Inflation - In balanced funds, equities provide the benefits of shielding the battle of inflation which if not managed can erode the purchasing power in the later years.

Tax Efficiency - Balanced Mutual Funds which have more than 65% in equity are taxed as equity funds. This means that for holding periods of less than 1 year, gains in balanced funds are taxed at 15% (Short Term Capital Gains Tax).

For holding periods of more than 1 year, gains in balanced funds over Rs 1 lakh are taxed at 10% (Long Term Capital Gains Tax). Gains up to Rs 1 lakh are exempt.

Dividends on Balanced Mutual Funds face a Dividend Distribution Tax (DDT) of 10%. This tax is cut by the AMC at the time of distributing dividends and hence the dividend is tax-free in the hands of the investor.

 

…and the cons

On the downside, the fund controls the asset allocation, not you—and that might not always match with the optimal tax-planning moves. For example, many investors prefer to keep income-producing securities in tax-advantaged accounts, and growth stocks in taxable ones, but you cannot separate the two in a balanced fund. You cannot use a bond laddering strategy— buying bonds with staggered maturity dates—to adjust cash flows and repayment of principal according to your financial situation.

The characteristic allocation of a balanced fund—usually 65% equities, 35%  debt—may not always suit you, as your investment goals, needs, or preferences change over time. And some professionals fear that balanced funds play it too safe, avoiding international or outside-the--mainstream market, hobbling their returns.

Performance…

 

There are 33 schemes under the aggressive hybrid funds category, allocating 65-80 per cent of their total assets to equities, while the rest is invested in debt and money market instruments. During market rallies, many schemes under this category increase their allocations to equity to more than 80 per cent which helps them deliver higher returns similar to that of equity-oriented schemes. In the equity portion, most of the schemes follow a multi-cap approach, though there is a tilt towards large-cap stocks. The schemes try to capitalise from both accrual and duration opportunities by investing in money market instruments, PSU and corporate bonds and G-Secs. NAVs of 14 out of the 33 schemes under the category were hit by the bond-rating downgrades and defaults in the recent bonds fiasco. Performance of these funds depends on how they fare during various cycles of equity and debt markets. Five-year rolling returns data calculated from the past seven years’ NAV history show that the top-10 performing funds under this category have delivered 15 per cent CAGR, which was higher than that of the Nifty 50 TRI (12.7 per cent).

Currently, 21 funds are under the category of balanced advantage or dynamic asset allocation funds, dynamically allocating between equity and debt based on equity-market conditions. Though this category was introduced post the re-categorisation of mutual funds in mid-2018, seven funds, including ICICI Prudential Balanced Advantage and Aditya Birla Sun Life Balanced Advantage, have been following this strategy for more than six years. The equity portion of the portfolio is always maintained at above 65 per cent. Hence, they are treated as equity funds for tax purposes. Most of these funds follow a hedging strategy by taking equity derivative positions when the equity market valuation appears high. This helps limit the downside while maintaining the equity allocation at above 65 per cent. The allocation to equity shares (unhedged) is 30-80 per cent in most funds. The debt portion is managed with a blend of accrual strategy and duration play. In the risk-return pyramid, the balanced advantage category is placed between aggressive hybrid and equity savings funds. One cannot compare balanced advantage funds with aggressive hybrid funds as the latter allocates 65-80 per cent to equity (unhedged). Hence, the participation of balanced advantage funds in equity rallies is limited. Performance, as measured by five-year rolling returns, shows that the top-five performing funds under this category have delivered 12.5 per cent CAGR over the past seven-year period, which was almost similar to that of the Nifty 50 TRI (12.7 per cent).

Balanced mutual funds have offered better risk-adjusted returns in the long run compared to equity returns. The 5-year rolling return and standard deviation of balanced funds are 13.2% and 2.9 respectively as against 12.90% and 3.47, 13.96% and 3.82 and 14.91% and 3.96 for large-cap funds, mid-cap and large cap funds and diversified funds respectively.

Selection…

How to select a balanced advantage fund wisely?

Quantitative Parameters

1.      Performance and risk analysis

This is to analyse if the fund has shown consistency in performance across various market periods with decent risk-adjusted returns.

Under this, the fund needs to be ranked on quantitative parameters like rolling returns across short-term and long-term periods, such as 1-year, 3-year, and 5-year as well as on risk-reward ratios like Sharpe Ratio, Sortino Ratio and Standard Deviation over a 3-year period.

2.      Performance across market cycles

You need to ensure that the fund has the ability to perform consistently across multiple market cycles. Therefore, compare the performance of the schemes vis-a-vis their benchmark index across bull phases and bear market phases.

A fund that performs well on both sides of the market should rank higher on the list.

Qualitative Parameters

1.      Portfolio Quality

Adequate Diversification - The scheme should not hold a highly concentrated portfolio. The portfolio should be well-diversified and the exposure to the top-10 holdings should be ideally under 50%.

Credit Quality - For debt component, you need to ensure that the fund does not hold a high proportion of low-rated (securities rated AA or below) or unrated debt instruments. A fund with a higher credit quality should be ranked higher.

Low Churn - Engaging in high churning can result in trading and high turnover cost. Therefore, you also need to consider the portfolio turnover ratio and expenses, and penalise funds involved in high churning, i.e. those funds with a turnover ratio of more than 100%.

2.      Quality of Fund Management

You also need to consider the fund manager's experience, his workload, and the consistency of the fund house. Therefore, assess the following:

The fund manager's work experience:   He/she should have a decent experience in investment research and fund management, ideally over a decade. But note that experience is not always enough. Some schemes managed by fund managers with 15-20 years of experience have not necessarily done consistently well for a long time.

The number of schemes managed:   A fund manager usually manages multiple schemes. Thus, you need to check if the fund manager is not loaded with a large number of schemes. If he is managing more than five open-ended funds, it should raise a red flag.

The efficiency of the fund house in managing your money:   Do your research about the fund house's consistent performance across schemes. Find out if only a few selected schemes are doing well. A fund house that performs well across the board is an indication that their investment processes and risk management techniques are sound and efficient.

Apt for…

Balanced funds can be considered by the following kind of investors:

New investors: For investors who are putting their money into mutual funds for the very first time, both equity and debt instruments are balanced in their portfolio, thereby ensuring that investors can watch their investment record reasonable growth whilst keeping their principal investment amount protected. A young investor who is having a predominant exposure to equity funds can diversify risk by investing in hybrid funds. This introduces debt gradually or in the proportion required. Equity hybrid funds or MIPs can be chosen as the case may be.

Conservative investors: Balanced funds are great options for conservative investors like retired people and those who want a long-term safe haven investment instrument. The reason why a large number of such investors consider balanced funds is due to the fact that they follow a balanced strategy which enables them to get the best possible outcome regardless of whether or not bond or equities markets are affected.

Investors who want better returns than investments in debt funds: Debt funds tend to provide returns of around 10% on average, but some investors do not mind taking on some additional risk, albeit marginal, to earn considerably higher returns. If you are one of these investors, balanced funds can work out to be very profitable.

Investors who want tax efficiency with stability: Investors who are looking at tax efficiency with stability can also opt for hybrid funds. Under the hybrid category, equity hybrid funds with 65% plus to equity or arbitrage funds are treated as equity funds for tax purposes. You can use these funds to get more tax efficient returns.

The right fund for you?

Balanced Funds are the most convenient investment instruments for the investors who want to gain good earnings on mutual funds, but do not wish to take the risk of stock market fluctuations. The equity-oriented balanced fund offer capital growth in the medium to long run, while the debt-oriented fund aims to generate steady risk-adjusted returns. Thus, the investors can gain substantial income on their investments.