The Balanced way of investing in Mutual Funds

Historically mutual funds have been classified either into Equity Funds or into Debt Funds. Any fund with an equity orientation is called an Equity Fund and any fund which aims at a stable return but with little or no exposure into equity is called a Debt Fund. However, there are quite a few funds in the Hybrid category that are either classified as Debt or Equity depending upon the debt-equity ratio that is maintained in the fund.

Equity Funds are considered to be the highest on the Risk-Return Tradeoff as the risk associated with the fund, i.e. the underlying volatility of the stocks is the highest for that fund and thus the return potential is also the highest. Debt Funds on the other hand have the lowest Risk associated and thus the potential for very high return is also not there.

Balanced funds are a combination of equity and debt. Equity oriented Balanced Funds maintain at least 65% of exposure in domestic equities and can invest upto 35% in debt securities depending upon the fund objective. In fact from the taxation perspective, the long term capital gains tax (Investments period of more than one year) is free for this category of Balanced Funds. The dividends earned on these funds are also tax free.

There are many types of Hybrid or Balanced Funds like MIPs, Asset Allocation Funds and Capital Protection Funds. But funds which are equity oriented with 65%-80% exposure in equity market but with some debt portfolio as well are called Balanced Funds. They basically try to mix the benefits of both the worlds so as to provide a one-for-all solution to its customers. It is quite a good choice for someone who wants to invest in equity market but is not too keen in taking risk on the entire portfolio. Balanced Funds usually have a good large cap stock portfolio with a mixture of good quality debt securities.

Why Balanced Funds?

Good for first timers:

Balanced funds are especially good for first time investors so that they avoid the market volatility by not opting for a 100% equity fund and yet get the return of the equity markets with a hedging opportunity with the debt portfolio. Some experts say it is very good for new-to-equities kind of investors.

Investing Cushion:

When the markets are in doldrums, balanced funds have always created a cushion as against equity funds when the market corrects. This can also be considered as a hedging technique as 35% of the portfolio is almost at all times in debt securities which is unaffected by the equity market volatility. Despite the high equity exposure, these funds have shielded investors better than pure equity funds when stock markets have been under pressure.

Therefore, by having lesser equity exposure, the risk is definitely under control but the returns also do not match with that of the equity returns. For example when the market crashed in 2008, an average well diversified equity fund fell about 53% whereas a balanced fund fell by about 42% only. So, it could save the fund by about 11% on an average but when the markets recovered, the equity funds would recover much faster whereas balanced funds would have more consistent lower returns.

Equity Taxation with Lesser Risk:

With debt long term capital gain taxation being increased to the 3 year horizon, debt funds have become quite unpopular. Balanced funds and arbitrage funds have gained popularity in the interim as these funds enjoy equity taxation.

Portfolio Allocation:

Since balanced funds provide a healthy mix of both worlds and are thus placed in between the equity and the debt funds in the risk-return tradeoff, it gets lesser affected if any of the assets underperform as it has a back-up of the other asset class. Thus, if equity underperforms, debt can actually help in hedging and also provide average return. On the other hand if debt funds underperform with the G-Sec average, the fund piggy backs the equity portion.

However, the converse is also true. In case of a bull run, the balanced funds do not gallop as fast as their equity counterparts.

How do Balanced Funds work?

The intrinsic goal of all balanced funds is to ensure a stable return when the market falls. So they have quite a contrarian goal as opposed to pure equity funds. Thus, when the stocks rise, the balanced funds should perform well, but when it falls, the performance should not fall very low.

Let us take an example that Sachin has र 1 lac portfolio in a regular Balanced Fund which has a fund objective of 65% of equity and the remaining 35% in debt. Thus, Sachin has र 65,000 of equity stocks and र 35,000 of debt securities. This was when the Sensex was 5000.

Now, let us assume there was a 10% rise in the equity market and the Sensex rose to 10% i.e. at 5500. Presuming that all the stocks in his portfolio have also risen by 10%, i.e. his stock portfolio of र 65,000 has now gone up by 10% of 65,000 i.e. र 71,500. So, the entire portfolio is now र 106,500 (र 71,500 + र 35,000). So, to maintain 65% of equity in the portfolio, the fund managers have to reduce the equity exposure to र 69,225 (65% of र 106,500) by selling stocks worth Rs 2275 and purchasing an equivalent quantity of debt securities.

This would bring the portfolio mix to 65% of equity and 35% of debt and this is done on a regular basis. The converse is also true when the market falls. Even though the illustration looks complicated, it actually does wonders to the stability of the portfolio. The portfolio systematically purchases equity when the market falls and sells when the market rises. This is what everyone should do but actually does the exact opposite. When the markets rose to 21000 in 2008 Jan, everyone chose to invest in equity but when it fell in end 2008, people feared the equity market and chose to stay away from it.

Experts say: Be greedy when others are fearful, Be fearful when other are greedy.

The strategic rebalancing of portfolio happens automatically and thus it is good for not-so-savvy investors who wish to invest and forget their portfolio for the long run.

Balanced Funds Performances in the last 10 years:

To understand the performance of Balanced Funds in the last 10 years, we need to understand the Balanced Funds Category Performance as a whole for the last 10 years, i.e. from 2006 to 2015 vis-a-vis that of Large Cap Equity Funds. This is a percentage return of the entire Fund Category as a whole irrespective of the funds and have been considered for the whole calendar year.

Source: Year wise Balanced Fund and Large Cap Fund returns taken from www.morningstar.in

From the above example, you can see that the balanced funds have sometimes done better than large caps and sometimes not. To evaluate the data, let us consider the years 2006, 2007, 2009, 2010, 2012 and 2014. In these 6 years, out of the 10 years, the Large Cap Equity Funds have given better return than that of Balanced Funds as there has been an upward rise in the Sensex in these years. However, whenever the market fell in the year 2008, 2011 and 2015 and in a volatile year like 2013 the balanced funds as a category has fallen less and thus we can conclude that these gave better return than that of large cap funds as a category.

The same can be seen in the graph above as well wherein the Blue Line is the Balanced Fund performance in the last 10 years and the maroon line is the Large Cap Equity Fund performance in the last 10 years.

Conclusion:

If you are a retail investor and wish to opt for a fund wherein you would like to invest and then forget the same for a good long time, then Balanced Funds can be one of the best suited solutions for your need. Balanced Funds are quite a good option as it provides exposure to both equity and debt securities but the same cannot be used as a comparison tool against pure equity fund returns. Balanced Funds are tax efficient as the long term capital gains are tax free and also the dividend received from balanced funds are also tax free.

You thus get to have the best of both the worlds - good exposure to equity with a 65%, equity tax advantage and yet a hedge towards the market volatility by having a 35% of debt securities. However, please ensure you consult your financial advisor or get your proper financial planning done before investing as it is your portfolio and the choice of investment is completely yours!