Balanced Mutual Funds - Mix of equity and debt

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   The stock market has been disappointing investors for the past five years. Market bellwether BSE Sensex has given a 2.74% annualised return amidst bouts of volatility. But what if you had mixed some bonds (or fixed income instruments in market parlance) with your equity investments? Well, you have fared a little better. According to Morningstar India, a mutual fund tracking entity, balanced funds, as a category, delivered an annualised return of 5.02% in the five years ended December 31, 2011, leaving behind large-cap equity funds (3.16%) and small- & mid-cap equity funds' category (2.97%). Does it make sense for an equity investor to invest in balanced funds now? Balanced funds offer a judicious mix of debt and equity. As equities are attractively valued with limited downside and interest rates almost peaking, one can now expect healthy risk-adjusted returns from balanced funds.  

Balanced funds are in India for almost two decades now. According to the Association of Mutual Funds in India, as on November 30, 2011, . 15,457 crore is invested in 30 open-ended balanced funds. Balanced funds, as the name suggests, try to offer an asset allocation tilted a bit towards equity. Typically, these funds invest 65-75% of their corpus in equities and the rest in fixed income instruments.

A young executive at the start of his career who wants to build a portfolio which is primarily invested in equities and rest in quality fixed income instruments can check out balance funds. "Balanced funds make a good portfolio choice for first time investors who are not aware of their risk taking capacity. Another plus point is moving toward an asset allocation or building a portfolio mix of equity and debt. A balanced fund, of course, brings in the right asset allocation. More importantly it brings in discipline in asset allocation that an individual investor may not necessarily have.

Investing in a portfolio that offers both equities and debt works for investors. Though equities offer spectacular long-term returns, they can provide low or even negative returns during an economic downturn. For a first time investor, the fall in value of his equity portfolio may be tough to handle. If his portfolio has got some allocation in debt, the interest income from such investments would offer some cushion. That is why these funds do well in downturns than diversified equity funds. In CY 2008, balanced funds lost 37.88% against a fall of 53.08% in large-cap equity funds and 59.01% in case of mid- and small-cap equity funds.

A similar performance was recorded in CY 2011, when balanced funds lost 13.47% whereas largecap diversified equity funds lost 24.33% and mid- and small-cap funds lost 24.99%.

Most investors have an uneasy relationship with volatility in the stock market. Most of them get attracted to equity in a bull run. But when the market starts going down, they trend to panic. Many of them try to sell their stocks even at a loss to get out of the market. A balance fund could offer some comfort to such investors. Balanced funds are less volatile compared to their diversified equity counterparts. Standard deviation, a statistical measure of volatility, proves the point. Standard deviation (SD) for balance funds in the last five years ending December 31, 2011 stood at 20.47. The SD for largecap diversified equity funds for the same period was 29.65 and 32.46 for small- & mid-cap diversified equity funds. For the uninitiated, lower the standard deviation, less the volatility. The adjoining table makes it clear that the balanced funds were less volatile than their diversified equity counterparts in three- and ten-year time frame too. Put simply, if you have an uneasy relationship with volatility, better stick to balanced funds.

Asset Rebalancing

Most investors know about the importance of asset allocation and rebalancing of assets periodically. However, only a few managed to practice the theory and earn superior risk-adjusted returns. Often investors fall prey to fear or greed and miss the opportunity to act. Balanced funds can be of help here, too. Fund managers have to stick to the asset allocation. Fund managers sell equity as it surges past the prescribed threshold, thus bringing money to safer fixed income. That works in favour of novice investors who need not necessarily understand when to book profits in equity investments. In falling markets, fund managers end up buying more equities, at cheaper prices. Balanced funds thus address the important challenges faced by investors, such as asset allocation and asset rebalancing, and bring discipline in investing.

Should You Buy?

Young investors looking to build a corpus to meet their medium- to long-term financial goals can invest in balanced funds. "The longer you remain invested in a good balanced fund, the better it is for your portfolio. Consider a balanced fund with a minimum one year horizon. Long-term investments in balanced funds also benefit from favourable tax treatment. "As balanced funds invest at least 65% of the money in equity, the fund is treated like an equity fund for purpose of taxation. If the investor remains invested for one year, the gains do not attract tax. It is better to opt for systematic investment plan to invest in balanced fund as most of the money is invested in equity. Sure, some smart folks would want to know why they can't manage two different funds — one equity and one debt. Sure, you can go ahead with the plan, but be prepared to pay higher taxes. Obviously, it will bring down the post-tax returns. The only and most important downside with balanced funds is the possibility of lower returns compared to diversified equity funds in the longer term. But then that would be the sacrifice you would be making for peace of mind.

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