Start investing in balanced MFs

These funds contain volatility better but might not beat the market during a bull run

Equity-oriented hybrid funds, also known as balanced mutual funds, are currently outperforming large-cap funds over the one-, three-, five- and even 10-year horizons, according to category average return data from Value Research, a mutual fund rating agency. One normally expects a pure equity oriented fund to outperform a hybrid fund, at least over the long term. Before you decide to pull your money out of large-cap funds and move into balanced funds, it is important to understand why this has happened and if such outperformance will continue.

Experts offer two explanations for the outperformance by balanced funds. One, these funds have a significant proportion of debt in their portfolios, which in a declining market enables them to stem the fall in their net asset value better than large-cap funds. Debt instruments take up a quarter or more of the portfolio of these funds.

Even over the longer-term horizon of five and 10 years, balanced funds have outperformed large-cap funds. Explains Vidya Bala, head of research at Fundsindia.com: “The equity portion of the portfolio of many balanced funds resembles a multi-cap fund, wherein there is a strong mid-cap bias. This is true of many of the better-performing balanced funds. And, midcaps have outperformed large caps in the recent past.”

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Will this outperformance of balanced funds over large-cap funds continue in the future as well? Says Ankur Kapur of Gurgaon-based wealth advisory firm ankuradvisory.in: “While balanced funds may outperform large-cap funds in a falling market, they are likely to lag when the market is experiencing a bull run.”

According to Bala, top-performing balanced funds might do better than large-cap funds because these funds take an aggressive, mid-cap-oriented stance in their equity portfolios and they also tend to benefit from a rally in the debt market. She adds that balanced funds are likely to underperform an equity portfolio comprising funds of all categories: large-cap, multi-cap, mid-cap and small-cap.

Balanced funds are a good stepping stone for novices entering the equity markets for the first time. Young investors also tend to have less money. Balanced funds provide a one-stop solution to them, offering exposure to both equity and debt within one fund.

These funds have a sizeable equity component. They usually maintain an allocation of above 65 per cent to equities to be eligible for favourable equity-like tax treatment. Therefore, you must have an investment horizon of at least five years while investing in them.

When choosing a balanced fund, look for outperformance over the benchmark and consistency over various time horizons. Since the primary purpose of a balanced fund is to contain volatility, ensure that the fund outperformed its benchmark in a falling market. Also check the fund’s mid-cap exposure. While a higher mid-cap exposure could translate into higher returns, it will also make the fund more volatile. “Conservative investors who want less volatility should avoid balanced funds with high mid-cap exposure,” says Bala.

As you grow accustomed to the volatility of equities, and have higher surpluses, move beyond balanced funds and build a diversified portfolio of your own. “Conservative investors may build a portfolio comprising index funds on the equity side and short-term funds with an average maturity of around one year on the debt side,” advises Kapur. The equity portfolio will cater to your growth needs while the more stable debt component will help you meet your occasional income requirements. Investors with higher risk bearing capacity may build a portfolio comprising all the four categories of actively managed funds and debt funds.