Balanced Funds are the new lifeline for Mutual Fund Industry. These funds are also known as hybrid funds. Balanced Funds are of two types i.e. equity oriented and debt oriented. Equity oriented balanced funds invest 65% to 80% in equities and balance in debt instruments. On the other hand, debt oriented balanced funds follow the reverse strategy and invest around 70% to 80% in Debt Instruments and balance in equity. They are also referred as capital protection funds. I explained the same in my post, Should i invest in Capital Protection Funds?
For practical purpose, Balanced Funds means equity oriented only. This post will discuss equity oriented balanced funds. Normally, analysts say that these funds provide best of both the worlds i.e. debt and equity. I beg to disagree. One of the best performing balanced funds of past, HDFC Prudence fund’s last one year return is -11%. It is not true that they provide best of both the worlds. Investment philosophy is like a switch of an FAN whether it is ON or OFF. In other words, either you are invested in equity or not. It is wrong to conclude that Balanced Funds are secure and risk-free. As i shared the example of HDFC prudence fund, the return of one year is less than some of the average performing pure equity funds. Therefore, the returns are dependent on investment philosophy. As i shared in my post on stocks, when to enter and exit the stock market. The same rule applies to Mutual Fund also.
During choppy/volatile markets, in direct equity exposure, High Dividend Yield Stocks are projected as the savior. For mutual funds, the balanced funds come to the rescue of the industry. A year back, no one was talking about balanced funds. The flavor of the town was mid cap and small cap funds. I do agree that Balanced Funds are relatively less risky compared to equity funds but it depends on the investment philosophy of the fund. Let me share with an example. Assuming you invested 100 Rs each in two funds i.e. Fund A (Pure Equity Fund) and Fund B (Balanced Fund). Fund A invested 100% and Fund B invested 75% in Equity. The return of Fund A is -10%, therefore, your Rs 100 is now Rs 90. On the other hand, assuming fund B invested in stocks that collapsed 20%. The Rs 75 will become Rs 60. Now balance Rs 25 will be Rs 27 due to debt investments (8% return). Therefore, Fund B’s value is Rs 87. In short, the return of Fund A is still superior compared to Fund B i.e. Balanced Fund. It is important to check investment philosophy of the fund for equity investment.
Another magical PILL prescribed by Mutual Fund doctors is SIP. I covered this in detail in my post, Why you should not invest in SIP? The strategy of the mutual fund advisor depends on the market conditions i.e. bull market or bear market. From an investor point of view, if the investment addiction still persists during bear market then you may consider Value Investing.
Balanced Funds – Why it is not a Good Option to Invest
There are only 2 possibilities in equity market i.e. Bull Phase and Bear Phase. Let’s check why balanced funds is not a good option to invest in both the phases.
(a) BULL Market: The maximum equity exposure of these funds is 80%. Assuming during a bull market, the fund manager is fully invested in equity. On an average, the returns during a bull phase are 30% provided entry and exit timings are near perfect. The investor cannot time the market but fund managers can. Going by the same example of Fund A and Fund B as shared earlier. Rs 100 invested in Fund A will become Rs 130. On the other hand, Rs 100 invested in Fund B i.e. Balanced Funds will be divided between Equity (Rs 80) and Debt (Rs 20). Assuming same return of 30%, Rs 80 will be become Rs 104 and Rs 20 will become Rs 21.6. Therefore, Fund B value will be Rs 125.6. In other words, the returns on Fund B will be lower than Fund A by 4.4%. In absolute terms, on an investment of every 1 Lac, an investor will lose Rs 4,400.
To deliver returns same as an equity fund, the balanced funds have to outperform pure equity funds by 5.5%. Therefore, if everything remains same, the investors will definitely lose during bull phase. Very conservatively, this fig is 4.4%.
(b) Bear Market: The biggest problem with Equity Balanced Funds is that any given point of time, the equity investment should not drop below 65%. In short, for every 100 Rs AUM, Rs 65 should be in equity. The reason being, for equity mutual fund, the long-term capital gain tax is NIL after 1 year. Whereas if the equity investment drops below 65% then it will be classified as the non-equity mutual fund. It will be taxed like debt mutual funds. During bear market, the pure equity funds have the option to reduce equity exposure and increase cash holding. For example, fund manager reduced equity exposure by 20% and now equity investment is 80% and cash holding is 20%. This leverage is not available with fund managers of Balanced Funds.
Assuming, at the start of bear phase equity exposure of a fund B is 75%. At max, the fund manager has the freedom to reduce 10% holding. Some of the conservative balanced funds are always near 65%. Therefore, now they are STUCK in a bear phase. In other words, these funds tend to underperform during bear phase compared to equity funds. It is a compulsion for them to stay invested. The only exceptional scenario is if the stock portfolio outperforms during the bear phase that is highly unlikely.
I can invest in balanced funds and willing to forego X% returns during bull market provided i am convinced that during the bear phase, these funds will outperform their equity peers. In that case, it will be right to conclude that Balanced funds are relatively safe, secure and risk-free compared to equity funds. As we observed that they tend to under-perform under both the bull and bear markets. Therefore, i am vary of these funds.
Words of Wisdom: As a wise investor, you always maintain a balanced approach to asset allocation. Any investment allocated for equity should be pure equity play. Else the asset allocation is not balanced. Secondly, as an investor i always look out for investment philosophy or theme. I personally include balanced funds in the confused category as it has its own set of limitations. There is no compelling reason to invest in these funds. As an investor, i can also invest 80% in pure equity and 20% in debt. During bear market, i have the freedom to make 80% as 60% or even 0% without disturbing balance 20%. Unfortunately, in the case of balanced funds, i don’t have that leverage. The only option is to make both 80% and 20% as 0% i.e. exit the fund.
An investor should always remember that Balanced funds are not immune to market movements. Your investment is always at risk. It is not an LAW that you should always remain invested in mutual funds and stocks. As i always advocate that during a bear market, NO Position in the market is SAFE Position :).
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Hey Nitin, You said NO to balanced funds, at the same time you said NO to SIP. What is the best medium to invest then for the person who cannot keep a constant eye on Stock market ?
Pse read my response. Good balanced funds are the best way to take exposure inn the market, specially if you do not have the time. I am not an agent, just an investor and request you to read up on which fund is doing well. Pse also be aware that the larger the fund, the more difficult it is to make a profitable entry or exit, even on good calls
If you can re-balance your portfolio once in a month then you may opt for value investing else there is no option but to invest through SIP. please check following post on value investing.
https://www.nitinbhatia.in/personal-finance/value-investing-alternative-sip/
Sir – i dont agree with you. Your scenarios and comparisons are not fair. You are loading the dice against balanced funds and then drawing conclusions. I have invested personally for 20 years plus in both sorts of funds and over a period of five years the returns are comparable. The difference is that Hybrid funds give you a reasonable exit option even in a bear market, whilst the equity funds have collapsed. You can check the average returns on ValueResearch.
You mention that equity funds can exit from equities in a bear market. If they are doing that then why is their Nav reducing much faster than Hybrid funds during a bear market. I have seen only Quantum mutual fund follow the policy of sitting on cash – and they do it in a rising market, when they feel the market is getting overvalued, so that they can invest in the bear phase. They do not disinvest in a falling market, which i do not think any fund manager does.
All funds that are managed by Mr Prashant Jain have done badly for the last two years. If you want to compare apples with apples, pse compare HDFC Equity with HDFC Prudence. They are both managed by him. You will see an under-performance by 70% in the Equity fund
He has been a great investment guru, but i think the size of his funds has been his downfall as he has no space left to manouvere in the market place
Thanks pradeep for sharing your views..It is always good to have healthy discussion to get both the perspectives. I think we both agree that cash holding is key to outperform the market during bear phase as you shared example of quantum mutual fund. As i explained in my post that balanced funds have limitation on this front. They cannot reduce exposure below 65%. Besides quantum, the cash holding of few other equity funds is now more than 20%. As you rightly mentioned they are waiting to re-invest but this leverage is not with the balanced funds. Hope you agree on this.
Secondly, if equity funds exit during bear phase then their NAV will not drop as you removed non-performing stocks from portfolio or stocks expected to perform poorly. In other words, the drop will less or remain stagnant. It’s a perfect strategy to follow.
I completely agree with you that size of the fund is a biggest limitation and normally big funds tend to under perform as i shared in my previous posts.
please share the criteria to identify/differentiate between big funds and small funds.
There is no standard definition and vary from category to category.
Nice information abt Balanced Funds…