Balanced funds - a good option for a first time investor

My article in Mumbai edition of Gujarati Mid-day today

http://epaper.gujaratimidday.com//epaperpdf/gmd/15122014/15122014-md-gm-11.pdf

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The English translation is as under:

“What are balanced funds? I heard an expert recommending these funds for a conservative investor.” Someone asked. “As the name suggests, such funds should be expected to maintain balance. Am I correct?”

Well, a balanced fund should be understood as a hybrid fund that invests larger portion in equity and some in fixed income securities. The word “balanced” might have been used as in the beginning one would have tried to maintain equal allocation to the two assets, viz., equity and fixed income. However, later on, the allocation changed due to changes in the Income Tax Act (the Act).

As per the Act, a fund is categorized as an equity fund if at least 65% of the fund’s assets are invested in equity shares listed in India. Equity funds enjoy better tax treatment as compared to the other categories. Due to this, the balanced funds invest more than 65% of the fund’s assets in equity shares.

Having said this, these funds are still less risky as compared to the equity funds and hence the same might be a good starting point for a new investor. Let us look at the performance of these funds, especially when the equity markets fell.

We looked at calendar year data of performance of scheme categories – these numbers are added for all schemes in a particular category.

In the last 10 years, there were two calendar years in which equity markets fell: 2008 and 2011.

BSE Sensex fell by more than 52% in 2008 and by more than 24% in 2011. In these two years, the balanced fund category lost 37.14% and 15.41%, respectively as compared to equity multicap funds category, which lost 53.90% and 24.60%, respectively.

As can be seen, the balanced funds lost much less than the pure equity funds in the falling markets. However, in rising markets, equity funds did better than balanced funds in 7 years whereas balanced funds outperformed the equity funds in 1 year.

Thus, we can see that in the rising equity markets, balanced funds do not rise as much as the equity funds, but they provide reasonable protection in falling markets.

It is this characteristic of the balanced funds that make them suitable for a beginner. The equity allocation provides potential of capital appreciation, debt provides cushion against steep fall and classification as equity funds result into better tax-efficiency.

Coming back to the numbers, it is important to note that these funds may also exhibit steep fall in value as can be seen from the performance in the year 2008. Balanced funds as a category fell by as much as 37% during the year. This is quite a steep fall by any standards. Hence, one should not expect these funds to provide complete protection when the markets fall. Even in 2011, when the Sensex fell by roughly 25%, balanced funds lost around 17% for the year.

However, there is a hidden benefit here. When the markets fall, the equity allocation loses value, but the debt allocation would not. This results into the equity allocation being lower than what one started with.

Let us say, the scheme started with Rs. 70 allocation to equity and Rs. 30 to fixed income. After a year, equity had lost 25% and fixed income had earned 9%.

This means, the year-end values of equity and fixed income allocations would be Rs. 52.50 and fixed income allocation would be Rs. 32.70. This means the equity allocation is below 65%. In order to maintain the fund’s status as an equity fund, the equity portion needs to be increased. This can be achieved by selling some part of fixed income component to buy equity. This process is also known as rebalancing.

This rebalancing results into the fund buying equity when the prices are low.

Balanced funds are good for beginners. However, as explained, one must understand the limitations of the same. Some of the biggest limitations would be:

1.     In rising markets, balanced funds may underperform equity funds

2.     In falling markets, the NAV of balanced funds may fall, though not as much as equity funds

3.     Long term returns from balanced funds could be lower than equity funds, if equity markets exhibit a long term rising trend.

Happy investing.

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.