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Balanced Funds: A Good Way to Start Your Mutual Fund Investments - Outside View by PersonalFN

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Balanced Funds: A Good Way to Start Your Mutual Fund Investments
Aug 30, 2012

Traditionally, we Indians are great savers but we are very conservative and rather reluctant investors too. As per the data released by Reserve Bank of India (RBI), about 47% of the household savings in India lay in deposits with banks. Contribution of equity assets, in the total financial assets of the household sector is very low - about 12%, which is much lower as compared against the global standards (especially the developed markets).The primary reason for this is, the element of uncertainty involved in equity, which makes many investors uncomfortable and stay away from it.

The mighty bull phase of 2002-08 however had changed the perception of many investors towards investing in equity assets. But only a few early movers, who invested on the onset of bull market, got immensely benefited. Having witnessed their success, others too started looking upon equity asset class as a hot cake; but since some entered during the last leg of a multi-year bull phase, they felt the blow when the negative ripples of the U.S. sub-prime mortgage crisis were sent to the Indian equity markets.

At present, although markets have recovered from the slump; they have generated no real returns for many investors over last 5 years. Memories of the bear market are yet to fade from the minds of investors. They have turned away from equities, considering them dreadful for the reason of having burnt their fingers. As a result, retail participation in equity markets recently fell to 7 year low. The state of equity oriented mutual funds is no good either. They have witnessed redemption pressure piling up (with every up-move in the market) and fresh investments are being done at snail's pace. Novice investors are worried about them being gotten caught between the tussle of Bull and Bear and are rather afraid of losing money just as some of their friends have lost.

Equity as an asset class is neither bad per se nor has it lost its potential of generating superior returns. Volatility is the nature of equities, but when invested at right valuations, chances of going wrong are less. While many fancy investing in stocks directly, it is noteworthy that the direct route to invest in equities requires special skill as timely decisions matters along with the art and science of stock picking. Thus given that, investing through equity oriented mutual funds is a much safer, time saving and often cost effective investment option.

If you are one of those who have not yet invested in equity mutual funds, although risk profile allows you to invest fearing the topsy-turvy rides of equity markets, then you ought to rethink to obtain effective real returns over the long-term. While your proclivity to be invested only in fixed income investment avenues may help you safeguard against the implied volatility of equity markets, you may not be able to generate the desired wealth over the long-term by secluding equities. If you find yourself confused in choosing between safety and returns then you could find solace in "balanced funds".

What is a Balanced Fund?

Balanced Funds is a category in mutual funds which invest both in fixed income instruments as well as equities in different proportions. Allocation to debt and equity depend on factors such as the outlook for equities, valuations, inflationary pressure and interest rate scenario among others. But generally in order to qualify as equity oriented funds (which make their tax treatment favourable); they (balanced funds)allocate 65% of their total assets towards equity and 35% towards debt.

Why you should invest in Balanced Funds?

Well, the first benefit which balanced funds offer is a set asset allocation - generally ranging between 65% - 75% in equity and the rest in debt and cash. However, extraordinary market conditions would not deter the fund manager to go beyond these limits and up or reduce the exposure to a particular asset class.

Also they (balanced funds) provide the benefit of diversification within each asset classes i.e. equity and debt. So within equity you benefit from wide diversification across stocks and sectors, while in debt, across fixed instruments and maturity of papers. Moreover, the hybrid nature of the product allows the fund manager of a balanced fund to increase exposure towards debt investments when outlook appears favourable to do the same, thereby facilitating in mitigating the risk (associated with equities) and rewarding investors with appealing returns. More often than not, balanced funds are more conservative in their approach than a plain vanilla equity fund which runs with a sole objective of profit maximisation. A balanced fund, as the name suggests, tries to strike a balance between risk and returns by taking optimum exposure to debt as well as equity. This may, to an extent, boil down your concerns about investing in mutual funds.

Do they hold Promise?

Balanced funds as a category have generated decent returns across time periods. Although they have not outperformed category of pure equity funds; they have not trailed by a big margin either. On the contrary, they have been a lot more stable (in terms of the risk as revealed by the Standard Deviation of 3.88%) than the pure equity funds (standard Deviation of 5.16%). Thus the risk-adjusted returns too have been superior in case of balanced funds, and they have also managed to outperform some of the key indices.

How balanced funds have fared?
  1-Yr (%) 3-Yr (%) 5-Yr (%) Std. Dev (%) Sharpe Ratio
Category Average of Plain Vanilla Equity Funds * 4.7 9.5 5.9 5.16 0.04
Category Average of Balanced Funds ** 6.0 9.0 6.9 3.88 0.05
Crisil Balanced Fund Index 7.5 7.2 7.1 3.58 0.00
BSE-Sensex 5.0 6.2 4.6 5.37 -0.02
BSE-200 3.9 6.1 4.7 5.46 -0.01
BSE-500 3.1 6.2 4.1 5.47 -0.01
NAV Data: August 17, 2012
Note 1: Returns over 1-Yr are compounded annualised. Standard Deviation and Sharpe ratio is calculated over a 3-Yr period.
Risk-free rate is assumed to be 6.37%; Note 2: *160 pure equity funds have been considered to calculate the category average.
Schemes with less than 1 year of track record have been eliminated. **19 balanced funds have been considered to calculate category average
(Source: ACE MF, PersonalFNResearch)

Performance across market cycles
  01-Aug-2005 - 09-Jan-2008 09-Jan-2008 - 09-Mar-2009 09-Mar-2009 - 05-Nov-2010 05-Nov-2010 - 17-Aug-2012
Category Avg of Balanced Funds 38.2% -44.8% 58.2% -4.7%
Category Avg of Plain Vanilla Eq. Funds 50.8% -56.3% 84.5% -8.3%
BSE-500 52.3% -60.4% 86.6% -11.5%
NAV Data: August 17, 2012
Note: Returns over 1-Yr are compounded annualised
(Source: ACE MF, PersonalFNResearch)

The study of performance across market cycles also supports the view that balanced funds are less risky. They safeguard you when the equity markets are on a downswing, although they may not look impressive to you when markets are strong and the Bull Run is galloping. The table above reveals that in the bear and the corrective phase category of balanced funds have managed to control the damage. However during the bull phases they have underperformed by a big margin.

Delving deeper into their performance across market cycles reveals that out of 19 funds which we studied, about 17 have outperformed BSE 500 by a margin of more than 10% during the bear phase of 2008-09. In the on- going corrective phase (where the markets are flat), 4 funds have outperformed BSE 500 with a margin of more than 10%. But in both bear and corrective market phases all 19 funds have outperformed BSE 500. Performance in the bull market phase of 2005-08 is not superior to that of BSE 500 as all funds have underperformed the index with a margin of more than 15%. However, during the recovery phase (bull market of 2009-10); 3 funds which had outperformed BSE 500 with a margin in excess of 10% in the bear market of 2008-09; managed to reduce the difference between the returns generated by the index and that by the funds. These funds underperformed by a margin of less than 15%. Notably, 1 fund from the balanced fund category has outperformed even BSE 500 during the recovery phase.

Our View:

We believe that balanced funds are a good investment avenue for investors who don't have much prior experience and exposure towards equity but want to start investing in equity mutual funds as their risk profile permits them to do. Balanced funds are conservative in nature as compared to pure equity mutual funds. They are in particular a good starting point for novice investors because they tend to be a lot more consistent during the bearish market phases but still generate decent returns in market upswings.

However, not all balanced funds are similar in performance. As mentioned earlier, very few manage to beat broader equity markets or give satisfactory performance in bull market cycles. This entails that one has to be careful while choosing on a fund for investments, because as an investor you may not be satisfied only with your fund falling by lesser margin. You would want your fund to generate decent, positive returns during the market upswings. Assessment of available options would make your journey smoother.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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