We have discussed earlier in our blog that, asset allocation is the most important aspect of financial planning (please see our article, Asset Allocation strategies for different age groups). A number of studies have proven investing according to asset allocation principles and rebalancing the portfolio on a regular basis, gives excellent returns and is the most effective way of meeting your financial goals. Asset allocation depends on the age, investment horizon, income and financial goals on the investor. Though there are no hard and fast rules for asset allocation, some commonly used asset allocation guidelines suggest 70% equity and 30% allocations, for investors between 30 to 40 years of age. Some asset allocation guidelines suggest that even investors in the age group of 40 to 50 years of age can opt of 70% equity and 30% debt allocations. Balanced funds which have 65 – 70% of their portfolio invested in equities and the rest in fixed income securities are excellent investment options for such investors.
While the difference in returns between diversified equity and balanced funds categories over 3 and 5 year time periods have not been significant, the volatility of returns is much lower for balanced funds compared to diversified equity fund. The chart below shows the comparison of annualized standard deviation of average monthly returns diversified equity and balanced funds categories over the 3 years, 5 years and 10 years time periods.
We can see in this example that by year 5 the equity allocation has increased to 76% and debt allocation has decreased to 24%, because the equity and debt investments have been growing at different rates. However, this has caused your portfolio to deviate from your asset allocation target and exposed your portfolio to higher risks. If the deviation from your target exceeds a certain tolerance band, you should re-balance your portfolio either by making fresh debt investment or by booking part profits in your equity investments and reinvesting in debt. This re-balancing happens automatically in balanced funds. Suppose a balanced fund has 70% exposure to equity and 30% to debt. If the market rises sharply causing the equity allocation to increase to 80%, the fund manager will sell 10% of the equity holdings to bring back the equity exposure to 70%. On the other hand, if the market falls the fund manager will buy more stocks to maintain the 70% exposure to equities.
Comparison of returns of balanced fund versus combination of equity fund and fixed deposit
Will you be better off constructing your own balanced portfolio or investing in balanced funds? Let us analyze with the help on an example. Let us assume your asset allocation target is 70% equity and 30% debt. We will examine two investment options:-
Let us now see how the returns compare after 5 years. The table below shows the return on the portfolio of the equity fund and fixed deposit.
Let us now compare the above with the return on the balanced fund investment.
We can see that the return on the balanced fund is Rs 1.08 lacs higher than the portfolio of the equity fund and fixed deposit. What if you had invested in a good long term income fund instead of fixed deposit in option 1? Sure, the return would be higher if you had invested in an income fund, since it is more tax efficient than a fixed deposit. However, the return on the balanced fund would still be higher
Conclusion
Balanced funds are excellent investment long term investment options. They can help you meet your asset allocation targets, help you with automatic rebalancing of your portfolio and are more tax efficient. If you have a more aggressive asset allocation target, combine your balanced fund investment with a large cap equity fund or a mid cap fund. If you have a conservative asset allocation target you can consider monthly income plans, which are another variant of balanced funds, for conservative investors (please see our article, Top 5 Mutual Fund Monthly Income Plans). However, as with all mutual fund investments, it is imperative that you select a top performing balanced fund. Difference in the performance of a fund in top quartile and bottom quartile is significant. You should consult with your financial adviser, if balanced funds are suitable for your investment portfolio.
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