“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” – Warren Buffett
In investing it is important not to lose money. We can avoid losing money in market by completely remaining out of the market. But if that were the intention, you wouldn’t have been reading it. You have to be “in it” to “win it”. So, how can we reduce possibility of huge losses? We can do this by having proper asset allocation and periodic rebalancing.
In this context, I recently came across an excellent video of Samir Arora in which he describes why a 60% net long portfolio might be better than 100% equity long exposure (See here, the discussion from 35th minute onwards). His main argument is that a 60% net long equity portfolio will most probably do better because it will fall much less than the market during corrections.
Now, when my portfolio falls less than the market, I have two advantages:
- A deep portfolio fall might leave me scared to deploy additional capital
- A deep portfolio fall might not leave much cash to deploy during period of corrections.
So, how a normal mutual fund investor can get 60-70% type of equity exposure with automatic periodic rebalancing?
What are balanced fund and what they offer?
As discussed above, an equity oriented portfolio can do equally well by having 60-70% equity allocation. Balanced funds offer exactly this. Balanced funds are those funds that have equity allocation between 65% to 100%. It can hold cash or fixed income securities between 0% to 35%. The key benefits of balanced funds are:
- Taxation: From taxation perspective, balanced funds are treated as equity funds. Hence there is zero tax for holding period of more than 1 year. One can replicate a balanced portfolio with 60-65% allocation to pure equity funds and 30-35% allocation to debt funds. However, such a structure will be less tax-efficient as investor will have to pay higher tax on the debt portion.
- Auto-rebalancing: Balanced funds have in-built portfolio rebalancing. This means that portfolio manager has to sell equities after strong performance (to reduce their weight) and buy equities when they do badly (increase weight when weight falls after equity underperformance).
- Downside protection: 0 to 35% fixed income allocation protects portfolios during market corrections.
- Stability: Unlike equity funds that may have to sell equity holdings due to redemption pressure during market corrections (as investors look to get out of equity), balanced funds normally have enough cash cushion to ward off redemption pressure.
Balanced funds Vs equity funds – comparing the performance
The equity market is near all-time high and has delivered strong recent return. If one looks at the fund performance at such a time, balanced funds should be expected to deliver relatively inferior return. Even after this, equity oriented balanced funds seem to have outperformed their large cap peers (based on data from value research). Indeed, over medium to long-term the performance of balanced funds, has been good compared to large cap diversified equity funds.
Why is now a good time to invest in balanced funds?
When we compare the performance of balanced funds with diversified equity funds, we notice that balanced funds tend to fall less when market corrects. It is a good idea to invest in equity through balanced funds when valuations have become expensive after strong return in recent past (How expensive is Indian equity market?). Historically, equities tend to suffer after strong equity market returns and rich valuations (as happened in 2008-09, 2011).
What to look for in a balanced fund?
Balanced funds that are generating equity like return, not by prudent asset allocation and rebalancing, but by increasing exposure to mid and small cap stocks or taking high interest rate risk (on debt portion of the portfolio) should be carefully analysed.
Recently I read an article in Economic Times (here) which talked about some balanced funds which might be risky. Investment should be made after careful analysis.
Finally, there is a strong case for balanced funds in all market environment
Balanced funds are good option for conservative investor. While these funds are especially more suitable when the valuation is rich, one can look for balanced funds across all market cycle. Our analysis of their performance suggests they deliver steady risk adjusted returns.
In our second article, we will look more closely at the performance and risk management qualities of balance funds with specific case studies. If you would like to be notified when we write next, subscribe to our newsletter below:
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
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