Balanced funds can be complex

Understand the strategy before investing in this currently popular category

A mutual fund distributor’s typical response to a risk-averse investor’s fear of pure equity funds is: Buy balanced funds. “The presence of debt will ensure that the downside is capped when the equity market falls, it will also give same tax benefits as equity funds...,” he will be quick to rattle off.   

No wonder, investors have been flocking to these schemes. From assets under management (AUM) of Rs 13,790.7 crore in January 2013, these funds now manage assets worth Rs 98,593.9 crore, a sevenfold increase. ICICI Prudential Balanced Advantage and HDFC Prudence are among the top five equities schemes with AUM of Rs 17,368 crore and Rs 16,469 crore respectively, according to data from Value Research.

As far as the marketing pitch goes, the distributor is not wrong. Equity balanced funds are much less volatile than an equity, especially mid-or-small-cap fund. Fund managers invest at least 65 per cent of their portfolio in equities. This allows them to give tax-free returns after one year of investment. The confusing part: How is the portfolio constructed? 

Two strategies for balanced funds: One, albeit a plain vanilla one, is to maintain an equity allocation of at least 65 per cent or more in direct stock exposure and the rest in debt. The 65 per cent can be in large, mid- or small-cap stocks, depending on the fund manager’s conviction. Similarly, the debt part can also be played around with. For example, if the fund manager believes the interest rate will go down, he can hold onto papers whose tenures are seven-eight years or more to take advantage of falling yields. Conversely, if there is a rising interest rate outlook, he can bet on short-term papers. 

The other strategy to have say 40 per cent in equities, 30 per cent in arbitrage and 30 per cent in debt. There can be several permutation and combination of this strategy, depending on the fund manager’s inclination and expertise. An arbitrage strategy is simply taking reverse positions in the cash and futures markets. So, if there is a stock which is trading at Rs 1,000 in the cash market and Rs 1,100 in the futures market, it would make sense to buy in the cash market and sell in the futures.

“Schemes that use arbitrage strategy are similar to income funds. They don’t fall as much as the broader markets but at the same time give better returns than pure debt funds,” says Pradeep Gokhale, senior fund manager, Tata Mutual fund.

Then there are companies that have three-four balanced funds. “Each scheme is aimed at an investor who is averse to volatility but would like to enjoy the benefits of equity exposure for long term wealth creation. For example, ICICI Prudential AMC has four funds. Each has a well-defined equity exposure differentiation, based on which one can take a call to invest,” says Manish Gunwani, deputy CIO-equity, ICICI Prudential AMC.

There are also debt balanced funds which have a dash of equity. They are classified as hybrid (debt). A retail investor either needs to do a proper research to understand the strategy, philosophy and differentiation or rely on expertise of an advisor to explain the best-suited fund for his profile.

For lazy or new investors: “Balanced funds are suitable for investors who have low-risk appetite or are new to equities. Those with more than seven-year investment horizon should look at funds that have higher equity exposure,” says Dhaval Kapadia, director, portfolio specialist, Morningstar Investment Adviser India. They also work well for those who don’t want to actively get involved in asset allocation. “A fund manager takes care of the asset allocation, and investors don’t need to rebalance it,” says A Balasubramanian, CEO, Birla Sun Life AMC.

But if you strictly maintain your asset allocation; then balanced funds are not for you. Their equity exposure can vary from as low as 35 per cent to even 80 per cent, depending on the market condition. “You also don’t have control over their investments strategies. If a savvy investor wants large-cap strategy for equity and accrual strategy for debt, they have to split their investments in two different funds to achieve this. A balanced fund may end up having exposure to mid-cap stocks or in its debt portion, it may follow a duration strategy,” says Vidya Bala, head of mutual fund research at FundsIndia.com.

Balanced funds can also be more expensive than maintaining separate asset allocation. Explains Rohit Shah, founder and CEO, Getting You Rich: Equity funds have an expense ratio of 2.5 per cent while debt fund charges 1.5 per cent. Even if a balanced fund charges you 2.25 per cent as expense ratio, it will be more expensive. Over the long term, as compounding takes place, such small costs matters.

Go for pure equities if age on your side: Diversified equity fund would generate better returns over the long term compared to a balanced fund. In the past three years, balanced funds and multi-cap funds have average returns of 19.04 per cent and 22.03 per cent respectively. A five-star rated multi-cap fund ICICI Prudential Value Discovery has better returns (29.17 per cent) than five-star rated ICICI Prudential Balanced (23.43 per cent) over three years. Over 8-10 years, equities as an asset class usually outperforms all others. A well-managed fund with higher equity allocation, therefore, would offer better returns.

These funds become popular after the taxation of debt funds changed in 2014 Union Budget. The short term capital gains tax period was increased from one year to three years. Following this, many existing funds changed their strategy. When selecting a balanced fund, an investor needs to focus more on the recent past.

They aren’t risk-free: Financial planners say that many investors think that lower volatility in a balanced fund means that they are risk free. What they fail to realise is that these funds invest in equities too. They are not risk free but are less volatile than diversified funds, which have higher allocation to stocks. “A lot of balanced funds have considerable amount of mid- and small cap exposure, which can make them volatile, too,” says Shah.

For regular income, MIPs work better: As these funds have equity exposure, individuals should avoid investing in them for regular income. Retirees are often advised to invest in dividend option of monthly income plans (MIPs) that have 15-25 per cent equity exposure and the rest in debt. The stock investment helps to increase the overall returns. Investment advisors say that balanced funds are not a replacement for MIPs. The former has higher equity exposure and dividends from them would not be consistent.