Balanced Funds Demystified: Part 2

In the first part of this post, Balanced Funds Demystified – Part 1, we discussed about risk return characteristics of Hybrid or Balanced Funds. The risk profile of a Balanced Fund depends on its asset allocation and some Balanced Funds (as discussed in Part 1) can have fairly aggressive risk profiles. Debt Oriented Hybrid Funds, on the other hand, have much more conservative risk profiles. There are other important nuances which investors should be aware of when investing in Balanced Funds, so that they are able to make the right investment decisions.

Equity allocation of a Balanced Fund may not always indicate the true risk profile

Equity oriented Hybrid funds or Balanced Funds have minimum 65% allocation to equity. 65% asset allocation to equity on average has to be maintained in order to enjoy equity taxation. Long term capital gains (investments held for a period of more than 1 year) in Balanced Funds are tax free. Dividends paid by Balanced Funds are also tax free.

However, the overall equity exposure may not indicate the true risk profile because a portion of the equity allocation may be hedged using derivatives. The purpose of hedging is to reduce risk. The active equity exposure or the un-hedged equity exposure indicates the true risk profile of the fund. Some Equity Oriented Hybrid Funds, which are commonly known as Equity Savings Funds, use hedging to lower the risk and still enjoy equity taxation. A fund may have 65% gross equity allocation but the active equity allocation may be only 40% if the fund manager hedges 25% of the equity portfolio by selling futures.

While hedging reduces the risk, investors should know that, the hedged portion of the portfolio will not generate any return or generate very low returns (through arbitrage); hence the return potential of these funds are also lower than Balanced Funds which have high active equity allocation. Some research websites categorize Hybrid Funds based on their gross equity allocation, but it is not the best categorization because they are comparing apples with oranges.

A few months ago an investor told me that a particular Equity Savings Fund was not a good scheme because it was ranked around 70 in the category with 100 schemes on a research website. I asked him, which category he was looking at, on that website and he mentioned to Hybrid Equity Oriented Fund. An aggressive Hybrid Equity Oriented Fund may have 75% equity allocation, whereas the Equity Savings Fund this investor was referring to may have only 40% active equity allocation.

How can the two returns be compared? Accordingly, in MF Research section of Advisorkhoj.com we have separate categories for Hybrid Equity Oriented - Balanced Funds and Hybrid Equity Oriented - Equity Savings Funds.

As mentioned earlier, scheme names or even scheme categories can sometimes be misleading. You should look at asset allocation and also the active equity exposure, by going the scheme information document and the factsheet (because active equity exposure may change from month to month). Balanced Funds whose active (un-hedged) equity allocation are more than 65% have moderately aggressive risk profiles, while funds whose active equity allocation are less than 50% have moderate risk profile. Investors should select the right fund based on their risk taking capacity.

No guarantee of monthly dividends in Balanced Funds

It is true that, many top performing Equity Oriented Hybrid Funds (Balanced Funds) have been paying regular monthly dividends for the last few years. Some investors and even financial advisors are now taking monthly dividend payout as granted, but in our view, the last few year’s track record should not be taken as an assurance of dividend pay-out. You should understand that, dividends are paid out from the accumulated profits of a mutual fund scheme. The equity market has had a great run over the last 5 years. As a result Equity Oriented Balanced Funds have sufficient accumulated profits from which they are paying regular monthly dividends to investors.

Past performance is not a reliable indicator of future performance especially for equity oriented mutual funds. If the equity market slows down or moves southwards, will the Balanced Mutual Funds be able to pay regular monthly dividends? No one knows and we will not hazard a guess as an answer.

However, we can look at the past to see dividend track record across different market conditions. If we look at the last 10 years history, some of the top performing Balanced Funds were able to pay annual dividends even when the market fell more than 20%. In fact, even in 2008, the worst bear market of our lifetimes, some of the top performing Balanced Funds paid annual dividends. This should be a good reference point for investors.

At the same time, in the 2010 to 2015 period some Balanced Funds, even in the top performance quartiles, missed out on regular dividends. Investors looking for regular dividends should therefore, study the dividend pay-out track record of different Balanced Funds over a long time period, across different market conditions and select funds based on long term (covering multiple market cycles) dividend payout track record.

Further, monthly dividend option is a relatively new development as far as Equity Oriented Hybrid Funds are concerned. There is not adequate volume of past data (2 – 3 years of dividend data is not sufficiently large sample) which can give investors confidence that these funds will be able to pay regular monthly dividends in a prolonged bear market. If the scheme net asset value continues to fall for a long time or if there are large scale redemptions due to market panic, the ability of the schemes to pay regular monthly dividends can be impaired.

We are seeing that many senior citizens or retired investors are looking to invest their fixed deposit maturity proceeds in Balanced Fund monthly dividend options with the expectation of getting much higher monthly income compared to fixed deposit interest. Top performing Balanced Funds are generating nearly 9 – 10% tax free dividend yields for investors, compared to around 7% fully taxable interest which fixed deposits are paying.

In the prevailing market conditions and interest rate scenario Balanced Funds dividend options are definitely better investment choices compared to fixed deposits for investors seeking regular income. However, investors must understand the risk associated with equity investments and be prepared for income disruptions in difficult conditions. How can senior citizens prepare themselves for income disruptions? Asset allocation is the most effective risk mitigation strategy. Balanced Funds have minimum 65% allocation to equity. To balance their asset allocation, investors should also invest a portion of their assets in debt funds or even Hybrid Debt Oriented Funds like Monthly Income Plans. These funds will be able generate income for investors, albeit at a lower rate, even when equity market are not doing that good and thus help investors meet their income needs till the market recovers.

Balanced Funds are suitable for long term investments

Some financial advisors think Balanced Funds are suitable for medium term investments while equity funds are suitable for long term. The definition of medium term and long term are little subjective. For some investors 3 years is long term, while for others only 10 years plus tenures are long term. Instead of getting caught up in the extremes, let us assume that 5 years plus is long term and 3 years is medium term. While over a three year investment tenure the likelihood of making a loss in Balanced Funds is significantly reduced, investors may not get their expected returns over 3 years or less investment tenure.

Take the 2010 to 2013 period – Balanced Funds as a category gave just 3.8% annualized returns during this period, which should be way short of the expectations of most investors. In our view, investors should be prepared to remain invested for at least 5 years, if they want to get the best returns from their Balanced Fund investments. In the last 5 years, Balanced Funds as a category gave on average 14.6% annualized returns, while in the last 3 years Balanced Funds as a category gave on average 10.4% annualized returns. 3 year returns of Balanced Funds can be high or low, depending on market conditions prevailing over most of the period. Over investment tenure of at least 5 years, even if there is a major correction or crash early in the tenure, your investment has sufficient time to recover and generate returns for you.

Conclusion

Balanced Mutual Funds are wonderful investment products. In the last 10 years, Balanced Funds gave nearly the same annualized returns as diversified equity funds (see Advisorkhoj Mutual Fund Category Monitor). The popularity of Balanced Mutual Funds has also brewed a number of myths or misconceptions about these products, which we have tried to clarify in this post.

Investors should be very clear about the risk characteristics of these products and not make investment decisions based on simplistic assumptions. Balanced Mutual Funds are more complex than equity mutual funds because they have allocation to equity as well as debt. But it is important to understand the asset allocation, so that you can make the right investment decisions. Many investors do not have sufficient time to do research. Your financial advisor can help you with the research, but you should educate yourself about investments so that you can ask the right questions and your financial advisor will help you get the answers.