Abhinav AngirishMany investors wish to benefit from compounding effect of equities by investing into them since equities can arguably provide the highest returns among all asset classes in the long run. However, they hesitate to bite the bullet due to highly volatile nature of equity markets. Lack of experience in dealing with equity investments further make them apprehensive of investing in equities. Such first-time equity investors can look at investing into balanced funds for equity exposure in their portfolio as such funds are less risky and less volatile than equity-only mutual funds.
Balanced funds are hybrid mutual funds that invest into both stocks and debt instruments so as to maintain a balance between risk and return. As balanced funds have a higher equity component, these schemes are also called as equity-oriented hybrid funds. As balanced funds invests into two different asset classes - equities and debt, returns depend on both equity and debt markets, which have very little correlation between them. Therefore, having exposure in both debt and equity a balanced fund provides the benefit of portfolio diversification.
Balanced funds not only have potential of higher return due to equity exposure but also offers stability to the portfolio due to their debt exposure. As compared to pure equity funds, balanced funds can provide some cushion to the portfolio in falling markets. Generally, balanced fund perform better compared to pure equity funds in a scenario when the equity markets are volatile due to ongoing rebalancing between debt and equities. Let us look at it in detail.
Balanced funds typically invest at least 65 percent of the corpus in equity, while the remaining portion is invested in fixed income instruments. One great advantage of balanced funds is that it automatically allows re-balancing between equity component and debt component. If the equity allocation increases due to rise in stock prices, the fund manager books the profit on some of equity component and re-invests the proceeds into debt component so as to maintain a desired asset allocation. Similarly if the equity allocation becomes lower than desired allocation, the fund manager invests more funds into equities to keep a desired asset allocation by selling some bonds. This provides for automatic re-balancing of the portfolio at regular intervals and thereby helps investors to earn better risk-adjusted returns.
In terms of taxation, for a scheme to be classified as equity scheme and avail of the tax benefits that equity scheme enjoys, it need to invest at least 65% of its portfolio into equity. Balanced mutual funds typically invest at least 65% of the corpus in equity and therefore are classified as equity scheme for taxation purpose.
If you make a gain on your investment in a balanced mutual fund scheme that you have held for more than one year, such a gain will be classified as long term capital gain (LTCG) and attracts no tax liability as the tax rate for LTCG on equity funds is Nil. If your holding period in a balanced mutual fund scheme is less than one year i.e. if you redeem your mutual fund units before 1 year after making a gain, then your profit will be considered as short term capital gain and will be taxed at the rate of 15%.
Balance funds provides the blend of growth and safety. Although balance funds may not generate returns as high as generated by pure equity funds during bullish markets but during market downturns they fall less than pure equity funds. Balanced funds are especially suitable for people who wish to have an allocation to both equity and debt. Due to classification of balance funds as equity schemes under present taxation laws, the whole debt component which comprises 30%-35% of the fund is also tax-free if holding period is at least one year. On the other hand if investment is made separately in a debt mutual fund scheme and held for three years to qualify for long term capital gain, still one is liable to pay 20% capital gains tax after indexation. If the investor chooses to invest in a debt fund for less than 3 years, the gains will be added to the investor's income and taxed at the investor's applicable tax slab rate.
In view of the benefits of balanced funds, first-time equity investors can give a serious look at investing into them for taking an equity exposure in their portfolio. However, take a long term view of at least three to five years. If you try to redeem units of a balanced fund, before completing one year, generally they do charge an exit load to the extent of 1% of the assets. It makes sense to remain invested across cycles to reap better risk adjusted returns from the balanced funds.
Author is managing director of investonline.in, a mutual fund distribution entity.
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