Profit from a Balancing Act

balancing risk and return is important in a volatile market, such as the one in 2010. Balanced funds could be your best option. These provide a mix of both equity and debt investments, thereby minimising risk. Balanced funds invest more than 65% of their assets in equity and the rest in debt securities. Such funds, despite a debt component, are treated as pure equity funds for tax purposes. So you end up getting tax benefits associated with the equity category.

Data for the past year indicates that many balanced funds have outperformed the broader market and a large number of diversified equity funds (See Top 10 Balanced Funds). A look at the category average for the past year shows that balanced funds delivered a return of 11.4%, which is only a tad lower than the returns from the Sensex and the average returns from the diversified equity category.

So, what led to this outperformance? Primarily, high allocation in equity (nearly 70%). “Their calls on the mid-cap space have added to the performance of the funds,” says Fahima Shaikh, assistant manager(products), IIFL. “Moreover, in a volatile market, balanced funds tend to perform better than equity- diversified funds due to its structure,” says Anand Shah, head (equities), Canara Robeco Mutual Fund.

In a falling market, if a balanced fund’s exposure to equity drops due to the erosion in market value of its portfolio, more stocks are bought to maintain the asset allocation. This means the fund usually buys low. Similarly, when markets go up, the fund is forced to sell stocks, meaning it sells high.

On the debt portion, these funds have started maintaining papers with shorter maturity periods. Currently, the biggest concern on holding long-term debt is the impact of rising interest rates. However, Shah dispels this fear as his fund adopts an accrual strategy, which means that the fund’s debt portfolio doesn’t run long maturities.

Risk-return Trade-off: Balanced funds are ideally suited for investors with a risk appetite lower than that of equity funds. Such funds have delivered higher risk-adjusted returns. This can be gauged by studying the funds’ sharpe ratio. A high ratio for most of these funds implies a high return per unit of risk(See Sharpe Ratio). Says Shah,“The debt component, along with a conservative equity strategy, automatically lowers risk and standard deviation for the portfolio.”

The Caveat: Having said that, bal- anced funds are not always the best bet. “Balanced funds work as an asset allocation product. In a year when equities do exceedingly well they may underperform equity funds,” says Dharmendra Grover, fund manager, SBI Mutual Fund.

Says Shaikh, one should ideally look at a 3- to 5-year performances because historically markets experience both bull and trough phases within such a timeframe.

If we look at the returns of balanced funds during the bull years of 2006, 2007 and 2009, one can see their relative underperformance compared with the equity diversified category (See Balanced vs Equity Funds). However, during the financial crisis in 2008, these funds lost only 42% compared with a 53% drop in returns by diversified equity funds. The category also performed in line with the markets dur- ing the volatility seen in 2010.

However, during the bull year of 2009, Reliance Regular Savings Balanced Fund delivered superior return of 75% compared with the category average of 60%. The fund also cushioned its fall to 36% compared with a 52% drop of the Sensex in 2008.

Also, among the top performers was HDFC Prudence that has consistently given superior returns in the past 10 years, with a CAGR of 26%.

Over the long term, Canara Robeco Balanced Fund too has been in the top quartile. Though the fund’s performance has dipped of late due to its lower equity exposure, the fund is optimistic and hopes to increase investment in equity.

Who Should Invest?

Currently, exposure to equity is imperative to stave off negative impact of inflation. Investing in debt alone would mean negative returns. For moderate risk takers, balanced funds work best since they offer an equity exposure of between 65-75% along with debt allocation. “Since balanced funds have a defined asset allocation, it ensures timely profit booking and re-allocation,” says Shah.

They also offer tax efficiency as these are treated as equity investments. However, investments in these should be made by way of systematic investment plans to balance out the uncertainties in equity and debt markets.