Six reasons why balanced funds deserve more respect

When it comes to containing downside, balanced funds are better positioned than most equity funds. Also they do not compromise much on the upside

November 04, 2015 / 08:19 AM IST

Tarun Birani
TBNG Capital

Rule No.1 - Never lose money. Rule No.2 – Never forget rule No.1
-Warren Buffett

This rule is precisely followed by balanced fund. Balanced funds invest over 65% in equity instruments with a view to earn long term returns and the remaining in debt instruments in an effort to reduce short term volatility. Balanced fund is an ideal option to have allocation in equity & debt, the two key primary asset classes. These funds are not meant to outperform the broad equity fund categories but are meant to provide superior downside protection. Thus delivering equity returns with lower volatility.

1) In built risk management

They are the best suitable products for those who want to participate in stock market but don't have the stomach for volatility. This is usually true for those investing in equity for the first time as the key motto of a first time investor is to protect the downside of their portfolio along with ripping the fruits of equity investments. The 35% allocation to debt helps reducing volatility & act as a cushion in volatile equity market.

Volatility measures the variation in return delivered by the selected category. The lower the number better it is for investor. The following analysis helps us to understand that the balanced fund category is comparatively less volatile from the others as observed all 10 observations are in favor of balanced fund.

Table No.1:








Source: FE Analytics


Table No.2: The recent crash









Source: FE Analytics


As we understand the superiority of a balanced fund is its downside protection in a highly volatile market. The above table act as evidence, where analyzing the recent market correction the least correct is into balanced fund category.

2) Automatic rebalancing

No single asset class outperforms or under performs in the same market scenario/time & also it’s not prudent to put all your egg in one basket which is why balanced fund becomes an effective investment option. We should understand that it is not only important to invest according to asset allocation but it is equally important to review and rebalance the portfolio periodically. The headache of rebalancing according to valuations is taken over by the fund manager and it’s done dynamically to provide a superior return which also becomes an added advantage in volatile market.

Chart No.1:












Source: FE Analytics, Debt-Debt income category


To understand the rebalancing feature let us take an example: Two friends Mr.Khushal & Mr.Dhushal both makes a lumpsum investment of Rs.1Lac, but Mr.Khushal invests 65% of his corpus in a pure-equity fund & 35% in a pure debt fund. Mr.Dhushal invests the entire corpus in a balanced fund. Balanced fund usually have a minimum equity allocation of 65%. At the end of 1 year both Mr.Khushal & Mr.Dhushal portfolio has grown by same amount. But Now Mr.Dhushal has an added advantage in a balanced fund that the fund manager can reallocate his portfolio to 65% equity & 35% debt. In reality the fund manager rebalances the portfolio on on-going basis, not on yearly basis.

Table No.3:






















Assumption :Return by Equity Portfolio 20%p.a
Return by Debt Portfolio 10% p.a

3) All weather fund
Table No.4:








Source: FE Analytics


From the above table we can understand that in case of an upswing in the market or a bull run, their returns may be lower than that of pure equity funds as their equity component is lower. But it also emphasis that it also protects the downside which can be noted in the year 2008 & 2011.Also to add in the year 2014 balanced fund have actually outperformed the Nifty and large cap category.

4) Tax efficiency

The beauty of a balanced fund also lies in the tax treatment .They are taxed as an equity fund even though they have an exposure of up to 35% in debt. That means the return from this category is tax-free if the holding period is more than one year. Dividends received by the investor are tax-free (without any dividend distribution tax). Even the debt portion gets a favorable treatment (at par with equity). If, on the other hand, you had invested in two separate funds, equity and debt, you would have to pay tax as per short term capital gain in case of the debt fund if the holding period is less than 3 years.

5) Mix of strategies

In the equity portion we also get exposure to mid cap & large cap strategy as per the market analysis of the fund manager. He can also take a call on increasing or decreasing allocation to mid and small cap stocks as per his market analysis. Same on the debt part the fund manager can also have flexibility to take a tactical call on duration strategy .Thus we get flavor of both Accrual & duration strategy on the debt part. This flexibility to use different strategies allows the fund manager to create alpha with limited volatility.

Chart No.2



















Table No.5: Actual Equity allocation of few balanced fund.















6) Power of 65:35 ratio

There can be an investment avenue which gives better return than its peers but while analyzing this it is important to note that if the higher returns are delivered with same risk or by taking higher risk. This means we should always analyze the risk adjusted return. The modern portfolio theory advocates investment in avenues which can give better risk adjusted returns. Sharpe ratio measures the risk adjusted returns. The higher the sharpe ratio, better is the risk –adjusted performance, it means more return per unit of risk.

Table No.6:








Source: FE Analytics


The above table helps in understanding that investments in balanced funds provide a better risk adjusted returns in 8 out of 10 observations.

Conclusion:

As you can see the arguments in the favor of balanced fund are plenty with justifiable data .Though the return from a balanced fund might not be as high as a pure-equity fund but they have the capacity of giving handsome return with relatively less volatility. We believe that these funds are ideal investment avenue for conservative investors to generate long term wealth.

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