How to gain from a balanced fund?
Investment in balanced funds obviates your need to invest in two different asset classes for asset allocation. Balanced funds also obviate the need to periodically monitor and rebalance different asset classes in predetermined proportion.
Mutual funds are like departmental stores of financial products where generally you get the option to buy various and numerous products ranging from pure equity to pure debts, including between them many products with mixture with varying proportions of debt and equity. Of all these, hybrid equity oriented funds or popularly known as balanced funds as a category is very excellent product. Let us understand various features and suitability of balanced funds.
What is the rationale behind working of the balanced funds?
Asset allocation is one of the basic fundamental principle of prudent financial planning which advocates scientific allocation of all your investible funds into various asset classes. These asset classes include equity, debts, gold and real estate in broader sense but in narrower sense it includes two major asset class i.e. debt and equity. So for the people, who invest in pure equity, either by way of direct equity or in pure equity schemes of mutual funds , have to separately invest in other debt products for proper allocation of their debts portion. The balanced funds cater to both the needs with one product as the balanced funds always have minimum of 65% of their investments in equity and the balance in debts with varying levels depending on the level of the equity market at any given point of time.
In additional to asset allocation, rebalancing of various asset classes periodically is also second very important and complementary principal to the asset allocation principle. So the internal proportion of value of different asset classes in your portfolio does not remain static over the period and it fluctuates over the investment period due to fluctuation in the market price of the equity investment. In the time of market boom, the value of equity component goes up and thus the ratio of allocation to equity also goes up during such time. In order to maintain the pre specified asset allocation, you need to liquidate/shift some of your equity holdings and use the funds for buying any debt product of your suitability. Likewise during the bear phase the value of equity goes down and thus the relative percentage of your holding in equity in value of your overall portfolio also goes down. So the dual principle of asset allocation and rebalancing helps you maximise your overall return by dynamically changing investment from one asset class to another while providing a cushion to your returns. Since the balanced funds have both the component of debt and equity and cannot have lesser than 65% of investments in equity at any given point of time, they have to continuously monitor the relative proportion of debt and equity. So the investment in balanced funds obviates your need to invest in two different asset classes for asset allocation. Balanced funds also obviate the need to periodically monitor and rebalance different asset classes in predetermined proportion.
Taxation aspect of balanced funds
Under the income tax laws any scheme of mutual funds where domestic equity shareholding of the fund is maintained at more than 65% at all the time on average basis, the same is treated as equity oriented scheme so balanced funds which maintain this 65% of investible funds in equity are treated as equity oriented scheme. The tax treatment of equity oriented scheme and debt scheme is different as regards holding period requirement as well as tax rate applicable. An equity oriented scheme qualifies to be long term if held for more than twelve months whereas in case you hold debt scheme you need to hold the same for more than 36 months to avail the concessional tax treatment available to long term assets. So any profits made on equity oriented schemes held for twelve months or less is taxed at concessional rate of 15% whereas the short term capital gains from debt scheme is taxed at the slab rate applicable to you. The long term profits on sale/redemption of equity oriented schemes is fully exempt under Section 10(38) under the income tax laws whereas the long term capital gains on debts schemes is taxed @ flat 20%(plus education cess and surcharge if applicable) after using the benefit of indexation on the cost of purchase. So though significant part of the profits in balanced funds may be attributable to the investments made in debt products by the fund house, you still reap the benefit of concessional tax of 15% in case of holding for 12 months or less and claim it as fully tax exempt if held for longer period.
Minimises the volatility in the returns
The investment in equity as percentage of overall saving in the country is very negligible. Investments in fixed deposits of banks and companies take the larger pie of the financial investments cake. This is primarily because the people generally want the comfort of fixed return and the investments in equity is treated as very volatile. This volatility of investing in equity is reduced to some extent by investing in balanced funds as part of the investments in debts at all the times provides cushion to the overall return and to the fluctuations in the return over the period.
For whom this product is suitable
Balanced fund as an equity investment product is suitable for the first time investors in equity as lower volatility in the returns will not frighten the first time investor and comforts them. Even if we go by the historical data, the returns generated by the balanced funds are no worse than those given by the large cap funds in the long run. The returns generated by the Large cap Category and Balanced funds as category are given hereunder for comparison.
As is evident from the data the returns for longer period are better for balanced fund than those generated by the pure large cap funds due to debt component in it. It is also evident from this table that as the period gets longer the difference in average returns between the balanced funds and large cap funds come down and even turns negative after 3 years. So though returns given by both types of funds are similar in the long term but since the balanced funds provide little more stability to the returns these are ideal choice for people who want to invest for the first time. Even this is better products for the people who are at advanced age and are near retirement or have already retired and cannot take the volatility of the market in their stride. Moreover the returns provided by Balanced Funds are tax free after one year, these provide better after tax returns to retirees. Since all of the funds accumulated by the retired people are not needed immediately and since returns of balanced funds are less volatile, the balanced funds comes to the rescue of retired people specially when the interest rates are coming down on all the debt products.
Even for the people with little lower risk profile balanced funds are better choice than pure large cap equity funds. However for the people with higher risk profile other products like midcap funds or small cap funds may offer better returns accompanied with higher risk of short term volatility.Balwant Jain is a CA, CS and CFP. Presently working as Company Secretary of Bombay Oxygen Corporation Limited. He can be reached at firstname.lastname@example.org