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5 Reasons Why You Should Opt For Balanced Funds - Outside View by PersonalFN

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5 Reasons Why You Should Opt For Balanced Funds
Nov 2, 2016

Neeraj Rastogi recently celebrated his 27th birthday. Focused on his career goals, Neeraj never gave his financial goals or investing a serious thought. The only savings he had over the past couple of years were bank deposits and a Public Provident Fund (PPF) account. With his expenses growing, he now realised his earnings from investments are insufficient to beat inflation. To make matters worse, the recent fall in interest rates got him worried.

At the birthday celebrations he shared his concerns with his friend Rahul, a financial planner. To grow his wealth, Rahul asked him to consider investing in equity through mutual funds. He briefed Neeraj about the risk and return potential of investing in equity. The 15-20% returns of largecap equity funds delivered over the past three-year period wowed Neeraj.

Ruminating on the conversation with Rahul, Neeraj realised it's time he begins investing in high yielding products and make productive investments. But due to the intermediate goals of upcoming marriage expenditure and buying a house, he is hesitant to incur high risk by investing a large proportion of his assets in equities. Rahul then enlightened him about balanced funds.

Balanced funds benefit from both the equity and debt component due to the tactical allocation. About 65-70% of the assets are invested in equity, with the balance is invested in debt. A combination of these asset classes offers a high level of diversification, hence, lowering the risk as compared to a pure equity fund. For a newbie investor, a balanced fund can offer several benefits.

If you are in a situation similar to that of Neeraj, here's why balanced funds might be the right option for you. Below are 5 benefits of investing in balanced funds.

  1. Cushioning with debt - For the risk-averse investor, debt provides stability to the portfolio. A balanced funds' exposure to debt securities provides the right cushioning from the volatile equity portfolio. They maintain an allocation of 25%-35% to debt, while a predominant portion being invested in equities. The allocation to debt serves two purposes. Apart from providing stability and earning interest, the returns are enhanced in a falling interest rate environment (as bond yields and bond prices are inversely related to each other) facilitated by a flexi-debt portfolio as far as the maturity profile is concerned.

    Over the past one year, this is exactly what happened. Due to the high market valuations, the Nifty 50 index returned just about 4%. In comparison, debt funds returned 9%-12%, thanks to the reducing interest rates. Therefore, it did not come as a surprise when balanced funds, with the benefit of debt, outperformed largecap schemes over the 1-year, 3-year, and 5-year rolling periods over the past year as on October 24, 2016.
    Better Performance Compared to Largecap Funds
    Better Performance Compared to Largecap Funds

    Returns are on a rolling basis and those depicted over 1-Yr are compounded annualised. Data as on October 24, 2016
    (Source: ACE MF, PersonalFN Research)
  2. Lower Risk - The diversification of assets across equity and debt and within the respective asset classes lowers the risk a balanced fund exposes you to. As seen in the table below, balanced funds have proved to be less volatile than largecap funds with an annualised standard deviation of 11.32% vis-a-vis 15.06% for the latter.
    Better Risk Ratios
    Mutual Fund Category Beta Correlation SD Annualised Sharpe SORTINO Jensen's Alpha
    Balanced Funds 0.76 11.81 0.29 0.62 0.53
    Largecap Funds 1.00 15.06 0.22 0.46 0.36
    Note: Largecap funds are less volatile than other categories of equity diversified schemes, hence, this category of equity funds can be termed as the closest alternative to balanced funds. Risk is measured by Standard Deviation and Risk-Adjusted Return is measured by Sharpe Ratio. They are calculated over 3-Yr period assuming a risk-free rate of 7.38% p.a. The Nifty TRI is used as the benchmark for calculating the risk ratios.
    Data as on October 24, 2016
    (Source: ACE MF, PersonalFN Research)

    The average beta of largecap funds has been 1. Meaning, they are almost in tandem with their benchmark - and this is expected, given their predominant exposure to frontline equity. On the other hand, beta of balanced funds has been much lower at 0.76, signifying they are less volatile or susceptible to market swings as compared to the Nifty TRI.

    Likewise, balanced funds have scored over largecap funds in terms of risk-adjusted returns as well, clocking a Sharpe Ratio of 0.29 as compared to 0.22 for largecap funds.

    So clearly, balanced schemes have turned out to be a better alternative in terms of risk compared to largecap funds over the past three years.
  3. Help arrest the downside - The pain of loss is felt more than the joy of gains. You do not want to be in a situation where the value of your portfolio is being eroded. However, if you invest in any market linked investment, you are bound to face market downturns. You need to be open to this risk if you wish to earn higher returns. The only relief you can secure is if your investment declines less than others.

    If you take a look at how balanced funds have managed to perform across various market cycles, you'll discover that balanced funds have managed to reduce their losses during the downside of the market vis-a-vis large cap funds. Of course, the upside has been restrained, but that's the trade-off you ought to accept. So, if your risk profile permits and you're just a beginner seeking to create wealth over the long term, balanced funds are a good option.
    Performance across market cycles
    Performance across market cycles

    Data as on October 25, 2016
    (Source: ACE MF, PersonalFN Research)
  4. Tactical asset allocation and dynamic management - When you invest in balanced funds, you stand to gain with a tactical allocation to equity and debt. But in a bull market, where the returns from equity run ahead of debt, the equity portfolio of a balanced scheme may command a a slightly higher weightage than 65%-70%. Thus, to maintain the required allocation, the fund manager may book profits in the equity segment and shift the proceeds to debt. As a result, the gains are captured in the schemes. Conversely, if the stock market falls, the allocation to equity may drop below the desired level. Hence, to raise the allocation to equity, the fund manager may shift the assets from debt to equity. Deploying this strategy, the fund manager tries to tactically allocate assets actively.
  5. A Single Fund for Investing Across Equity and Debt - A thought may cross your mind, that if you invest in the best equity funds and best debt funds, by maintaining the same asset allocation as a balanced fund, you can do better in terms of performance. However, this means you need to put in extra efforts to pick two different schemes. Not only this, you require to monitor the asset allocation on a regular basis. If you need to buy and sell the mutual funds to maintain the right allocation, you cannot ignore the tax implications. The capital gains tax norms are different for equity and debt schemes. Doing this becomes a gruelling task for a first-time investor. In a balanced fund, you do not need to worry about all this. Being an equity-oriented scheme, the capital gains are tax-free after a holding period of one year.

To conclude...

In short, balanced funds are better equipped to handle the disposition of a nascent or risk-averse investor. You get the benefits of both worlds-equity and debt-in a single fund. Balanced funds potentially come with the inherent ability to deliver inflation-beating returns, while keeping the risk in check. To deal with market risk, you can invest in balanced funds through a Systematic Investment Plan (SIP) to power your portfolio with the benefit of compounding and gain from rupee-cost averaging. However, sow and allow an investment horizon of three years or more to reap sweet fruits.

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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