Balanced Funds: Twin advantages of tax and rebalancing
Balanced fund as the name suggests is a combination of equity fund and debt fund in one single product.
Given the favourable tax treatment of equity oriented balanced funds, an investor may wish to consider the benefits of investing in such funds. Let us start with understanding structure and tax treatment applicable for two flavours of hybrid or balanced funds having equity and debt both in the fund portfolio. Then we will compare alternative ways to implement the same investment strategies.
Balanced fund, as the name suggests, is a combination of equity fund and debt fund in one single product. Going by the heuristic, the natural combination is 50 percent of money invested should go into equity and 50 percent in debt. However, the funds investing in both debt and equity in India are generally having two very different variants. First, Debt oriented balanced funds (MIPs) and Second, Equity oriented balanced funds (The Balanced Funds).
The debt oriented balanced funds or monthly income plans (MIPs) target to invest anywhere between 15-25 percent into equity and 75-85 percent into debt. They are ideally suited for cautious investors looking for regular income with capital protection, but at the same time looking for enough growth to counter inflation. Also, pertinent for investors in retirement phase of lifecycle. However, this category of funds receives tax treatment of debt funds. Tax norms have changed for the worse as far as debt funds are concerned. The long-term capital gains period has been changed to three years and long term capital gains tax applicable after three years is 20% with indexation benefits. It’s a sheer coincidence that debt funds have delivered very good returns since 2014 on the back of series of rate cuts by RBI and therefore those who invested their hard-earned savings into debt fund or debt oriented funds may end up paying substantial long-term capital gains tax, if they decide to book profit after completion of three years of their investment.
Equity oriented balanced funds or simple balanced funds are treated as equity funds as far as tax treatment is concerned, if they maintain at least 65 percent of investments in equity on average. Such funds normally maintain 65-75 percent in equity and 25-35 percent in debt. Now this category of balanced funds has got a significant edge over debt funds or debt oriented mutual funds, especially after change in tax treatment for debt funds in 2014 as mentioned earlier. Such funds are best suited for investors with moderate risk profile.
Let us understand this by a stylized example of an individual with moderate risk profile and looking at investing 65 percent into equity and 35 percent into debt and is reluctant to make frequent changes to rebalance his portfolio for reasons such as exit load, short term capital gains tax etc. looking for investing at the end of Jan 2007 for ten years. There are at least two different ways in which he can achieve this –
A. investing 65 percent in an equity fund and 35 percent in a debt fund and not rebalance ever; or alternatively
B. investing in a balanced fund targeting to maintain 65 percent in equity and 35 percent in debt expecting rebalancing to be done periodically by the fund manager.
To facilitate comparison between these two alternatives, we have used BSE 10-year sovereign bond index as proxy for debt fund and BSE 100 index as proxy for equity fund. The stylised balanced fund tries to maintain 65 percent into BSE 100 index and 35% into BSE 10-year sovereign bond index by doing necessary rebalancing at the end of every month.
While both the alternatives look apparently same, they are different in at least two ways.
1. Balanced fund is treated as equity fund and therefore there won’t be any long-term capital gains tax after one year of holding, whereas investing separately in debt and equity funds will attract long term capital gains tax at 20 percent rate with indexation benefits after at least three years of holding on debt fund in the portfolio. The tax liability can be substantial in falling interest rate regime and that reduces post tax gains of debt funds substantially compared to the debt portion of the balanced funds.
2. Balanced fund needs to maintain minimum 65 percent exposure in equity for maintaining its status as equity (oriented) fund and continues enjoying favourable tax treatment. Hence, such funds are forced to buy more by selling part of debt portion of portfolio at the time of sharp declines in the equity markets dragging the equity portion of balanced fund below the floor of 65 percent.
While tax advantage of balanced funds is obvious, we tried to quantify the advantage of portfolio rebalancing in balanced fund vis-à-vis investing 65 percent in equity and 35 percent debt without rebalancing for 10-years’ period ending February 2017.
The above table shows return of BSE 10-year Sovereign bond index (proxy for bond portfolio), BSE 100 index (Proxy for equity portfolio). We compare two different portfolio choices. Portfolio A begins with 65 percent equity and 35 percent debt portfolio but is not rebalanced at any point of time during 10 years. And portfolio B is a balanced fund where 65 percent equity and 35 percent debt investment is rebalanced on monthly basis to maintaining desired 65:35 equity-debt mix.
Leaving obvious favourable tax treatment of balanced fund over 65 percent equity fund and 35 percent debt fund investment separately, we try to focus on the less talked-about benefit of balanced funds. Unbalanced portfolio A delivers 10-year CAGR of 8.02 percent, whereas Portfolio B outshines portfolio A by delivering 10-year CAGR of 10.32 percent! A clear 2.3 percent advantage over unbalanced portfolio. Power of rebalancing creates this outperformance as this forced discipline must be followed by fund manager. What we can also see is that such superior returns come with almost the same standard deviation and worst down month return, which means such rebalancing adds to returns without adding to risk even a bit. Of course, the best month return is clear 3.47 percent higher than portfolio A.
Based on the above comparison we believe that while there is a clear tax advantage of investing in balanced fund compared to investing in equity fund and bond fund separately, the bigger advantage comes from the disciplined rebalancing that takes place in balanced fund and that makes balanced fund far superior product. The advice to investors with balanced risk profile looking for 65-70 percent equity and 30-35 percent in debt must look at balanced fund rather than investing separately in an equity fund and a debt fund.The writer is Founder and CEO of InvestmentWaves.