Balanced Mutual Funds, as the name suggests, invest in a mix of equity and debt. In fact, a balanced fund does the job of asset allocation on your behalf. Instead of you making the decision of how much to allocate between equity and debt, the balanced fund takes that decision. Also, it gives you the added benefit of professional fund management and professional asset selection. Some of the Top Balanced Funds have given returns of between 15-19% over a 10-year period. This return is much higher than what pure debt funds have given in the same period and only slightly lower than what pure equity funds have given.
The big tax advantage of balanced funds
The big advantage for investors, that has attracted investors, has been the tax benefits available on balanced funds; akin to that of equity funds. Previously, balanced funds with 51% exposure to equities were classified as equity funds for taxation purposes. However, that definition was changed post 2006, when only balanced funds with a minimum exposure of 65% to equities were classified as equity funds. So what are the benefits of being classified as equity funds for tax purposes? The answer lies in the way capital gain is treated.
While dividends paid out by equity funds and debt funds are tax free in the hands of the investors, the treatment of capital gains is slightly more favourable in case of equity funds. Capital gains on a debt fund are classified as short term if it is held for less than 3 years and taxed at your peak rate. If you hold the debt funds beyond a period of 3 years then it becomes long term capital gains and is taxed at either 10% without indexation or at 20% with indexation. On the other hand, equity funds capital gains are treated as long term if they are held for more than just 1 year. In case of equity funds, short term gains are taxed at 15% while long term gains are tax-free. That is why balanced mutual funds become critical. They not only get the benefit of equity exposure but also are more tax-smart.
Getting it right both ways
The Best Balanced Funds have managed to mix a bit of aggression with their asset mix. For example, the equity mix has been slightly tweaked to focus more on high performance sectors and go underweight on laggards. Similarly, the equity stake has been tweaked from 65% to as high as 75% in some cases to make the best of the equity market rally. Such aggressive practices are also visible on the debt side. For example, when bond yields were headed down post demonetization, there was a shift to the longer end of the bond curve to make the most of the price movement. These little bits of aggression do create some risk but then that is what professional fund management is all about.
Why portfolio evaluation of balanced funds is critical
While the idea of balanced mutual fund appears to be quite appealing, there are some basic tests that you need to conduct to ensure that you are getting into the right balanced mutual fund. Consider the equity component. Fund managers maybe inclined to focus more on mid-caps and small caps as they have given the alpha during the last couple of years. But that is fraught with risk as they normally tend to be more volatile in challenging times. While exposure to mid-cap equity is understandable from the returns point of view, there is a risk that one needs to factor in. A similar test needs to be applied in case of debt too. Here too, funds tend to shift a little more in favour lower-rated bonds to prop up their returns. While some credit diversification is understandable, one needs to be cautious about too much exposure. Similarly, too much focus on long duration bonds means that in the event of the RBI hiking rates, the debt portfolio could see heavy losses.
Balanced Funds versus Dynamic Funds versus Monthly Income Plans (MIP)
Within the balanced category, there are three further sub-classifications that investors can consider. At the outset, there is the equity balanced fund that has a 65% or more exposure to equity and the balance to debt. Remember, a balanced fund tends to keep its exposure to equity and debt fairly static with minimal tweaking of exposures. Equity oriented balanced fund is attractive due to its tax benefits on par with equity funds. A dynamic fund, on the other hand, has the leeway to switch its equity/debt mix aggressively. There are times when Dynamic Funds tend to outperform the balanced funds but it is more aggressive in nature and therefore more risky. A dynamic fund can go up to 100% in debt and 0% in equity and vice versa depending on their view. Lastly, MIPs are also called Balanced Income Funds as they have a larger exposure to debt and a smaller exposure to equity. Consequently, MIPs (Balanced Income funds) do not get the tax benefits on capital gains, which is why they tend to be structured as monthly income plans to avoid the tax on capital gains.
Balanced funds have seen their collections jump two-fold in the financial year 2016-17. However, investors need to be cautious of the risks involved. While they do offer higher returns than debt funds and are also tax efficient, there are portfolio risks that investors need to be conscious. Otherwise, it offers an interesting alternative to investors!
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