July 28, 2014

Balanced funds may be riskier than you think

Balanced funds are widely understood to be funds that invest across equity shares and debt instruments, but with a slight tilt towards equity shares.  In India, to attract investors with tax benefits, over the years, that tilt has increased.  As things stand today, it would be unlikely for a balanced fund to hold, on an average, less than 65% of its portfolio in equity shares.

For a number of people, balanced funds represent a sweet spot between debt funds and equity funds- “the best of both worlds,” so I am often told.  Most advertisements, articles, and literature seem to encourage that view.  In the eyes of most people that I speak to, in a bull run, these funds are expected to do nearly as well as equity funds, while in a bear phase these are expected to protect the downside risk better than those funds.  While these are generalizations which theoretically appear sound, in this post I’d like to delve into some specific issues related to the risk in these funds.  In case you’re an investor in one of these funds, wondering whether to continue holding these, or you are someone who is considering investing in one of these, this post may help you make a more informed decision.

Don’t go by the name: There is at least one fund with ‘Balanced’ in the name, that is described by its fund house as being an equity fund (and not a balanced fund).  There are also funds that are described by their respective fund houses as being balanced funds, something that you wouldn’t know from their name.  The only sure way to know is by going through the investment objective.  Another way could be to go by the fund categorization of Value Research (Hybrid – Equity-oriented).

All balanced funds are in the ‘brown’ category:  Effective July 2013, fund houses are required to group their funds into three categories, distinguished by color, based upon the level of risk to one’s principal.  While the effectiveness of this coding itself is a matter of debate, as far as I have been able to make out, all balanced funds, along with all equity funds have been lumped together as high risk investments (brown color).  One could infer that within the framework of this coding, there is no significant difference between balanced funds and equity funds.

It is possible for a balanced fund to fall more than an equity fund: The rise or fall in a fund’s NAV depends upon the rise or fall in the prices of the underlying investments.  A balanced fund’s equity investments, as a percentage of the portfolio, will usually be less than that of an equity fund’s.  However, it is possible that the fall in value of those investments be more than those of an equity fund.  In the bear phase of 2008-09, going by data from Value Research, the worst performing balanced fund fell by over 74% from its peak.  To put that number into context, this fund underperformed 98% of the equity funds (including sector funds).

The equity allocation may be more than you think: Based on my conversations with investors, I gather a perception that a balanced fund would usually have 60%-70% of its portfolio in equity shares.  Based upon data from Value Research, as on 30 June, 2014, 12 of the 15 largest funds in the category, ‘Hybrid Equity-oriented,’ had equity investments in excess of 70% of their portfolio (most were closer to, or above the 75% mark).  One of the funds had over 81% of the portfolio in equity investments (its objective allows it to go up to 100%).

There is risk in debt, as well: Going again by data from Value Research (as on 30 June, 2014), if interest rates were to rise by 0.5%, the value of the debt instruments in the portfolios of some of the largest balanced funds could go down by close to 3%.

There is nothing wrong with taking risk so long as we are clear about the nature of risk and consciously make our choices.  Personally, I avoid most hybrid funds.  Most of these have investment objectives that are too vague for my comfort.  Further, investing in these means agreeing with whatever allocation the fund manager chooses to have between equity and debt, and also the choice of strategy and instruments in each of these investment categories.  As I see it, investing in separate funds for each investment category gives me a lot more clarity and flexibility. 

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