Friday 22 February 2008

Systematic investment in balanced funds is good for long-term investor

If you want to maintain a simple portfolio and yet have the benefits of diversification, a systematic investment in balanced funds is a great option

As an investor, if you are saving regularly for the long-term and want a low-involvement, hassle-free instrument, then balanced funds are the right choice.

Balanced (mutual) funds have been around for over a decade — and manage assets of over Rs 16,000 crore between them. They, by mandate, invest at least 65% of their portfolio in equities, and up to 35% in debt and related instruments. In practice, the equity component of most balanced funds varies between 65% and 80%, depending on the fund manager’s outlook of the markets. Long-term and discerning investors would no doubt have heard of the UTI Balanced Fund and Prashant Jain’s HDFC Prudence Fund.

Of course, today, there are over 15 balanced funds offered by different fund houses. They have systematic investment plans (SIP), growth/dividend options, and all the other investor-friendly features provided by ‘pure’ equity and debt funds.

But how effective are balanced funds from a tax, load and performance point of view, compared to, say, investing partly in equities and partly in debt? For those who do not wish to enter into nitty-gritties, here’s the simple answer: if you want to maintain a simple portfolio, and yet have the benefits of diversification, a systematic investment in balanced funds is a great option.

If you are the more discerning and involved kind, you might want to synthetically ‘manufacture’ a balanced fund type of portfolio instead; by investing in two or more funds, each of ‘pure’ equity and debt nature. If you want some mathematics around, how we came to this, then read on!

For a fair comparison, we consider a Rs 100 investment for three years in a balanced fund on the one hand; and compare it with a combination of two investments for the same duration — of Rs 65 in an equity fund and Rs 35 in a debt fund. Of course, if your desired asset allocation is far different from this (say you are risk averse and want to stay away from equity markets), you should not consider balanced funds. We assume an annualised equity market return of 15% and a debt market return of 7%. Thus, the balanced fund return, ceteris paribus, is expected to be 12.2%, before load and tax.

Nature of portfolio

Balanced funds would invariably invest the equity component of the portfolio in a well-diversified basket of securities, in different sectors. This is ideal for an investor who wants to participate in the long-term growth of the economy, without any active sector or stock preference. Indeed, balanced funds are best suited for such investors. For someone wanting to take sector calls or ride a mid-cap rally, a ‘pure’ (sector or mid-cap) equity fund exposure is called for.

A balanced fund would invest in debt securities of intermediate duration (1-4 years). Thus, they are sensitive to interest rate movements, but not overly so. Hence, as with equity, they are again suitable for investors without a clear researched view on rate cycles.

Transaction costs

In any mutual fund investment, there are two kinds of transaction costs — viz entry/exit loads (for purchase or redemption of fund units) and the expense ratio (annual cost of fund management).

Let us examine each of these in the illustration given above. Most balanced funds, unfortunately, charge the same entry load as equity funds (2.25%).

Thus, in our numerical example, of the Rs 100 invested in the balanced fund, only Rs 97.8 would go towards allotment of units. In our synthetic example, the entire Rs 35 would go into debt units (there being no entry load), and Rs 63.57 towards equity units. Thus, in the synthetic case, we have escaped paying entry load on the debt part of the investment. This difference gets magnified with time, due to compounding.

The other major cost — the expense ratio — is (at least currently) similar in the balanced and synthetic fund scenario. In fact, the difference between funds of similar category exceeds the difference between the equity and balanced categories. So, we ignore this term in the comparison.

Tax implications

There are two tax structures in mutual funds, depending on whether a fund is classified as debt or equity. The following table summarises the currently prevailing tax structure:

Thus, equity funds enjoy beneficial tax treatment. Here, balanced funds enjoy the beneficial treatment of being taxed like equity funds and, in this, they clearly score over the synthetic portfolio we had manufactured, where the debt portion would be taxed at a higher rate.

Balanced funds have higher transaction costs, but are beneficial from a tax perspective. Let us now examine the net impact of all these factors on returns earned by a typical investor.

The accompanying table shows the net impact in both the balanced fund investment and the synthetic portfolio; for the period of three years, given the equity and debt returns as assumed above. As can be seen there, the synthetic portfolio outperforms, but by a very small margin. For all practical purposes, a good balanced fund can easily perform as well as a synthetically-made portfolio with similar debt to equity ratio. And we do have such excellent balanced funds in today’s mutual fund market!

As an investor, if you are saving regularly for the long term and want a low involvement hassle free instrument, balanced funds are for you. If you otherwise have a lot of debt investment (Bank FD, PPF, NSC, liquid funds, etc) then you might be better off going for 100% equity oriented funds instead. In either case, you can be comfortable in the knowledge that the benefits of one option over another are not overwhelming; and in most cases not even significant.