Which is the right balanced fund for you?

‘Don’t put all your eggs in one basket’ — the adage also rings true for diversifying your investments across different asset classes. Allocation to different asset classes helps investors achieve positive returns over any given period. This is because the underperformance in one asset class can be mitigated by the outperformance in others.

Hybrid funds, with a broad range of asset allocation strategies, are a good means to diversify your portfolio and reduce risk. There are variations within the hybrid fund category — aggressive hybrid, balanced advantage or dynamic asset allocation, multi-asset allocation, equity savings, conservative hybrid and arbitrage. These funds invest across equity, debt, arbitrage opportunities and also gold.

Each hybrid category follows a different asset allocation pattern as prescribed by the market regulator. In the equity portion of the portfolio, these funds hold a blend of large-, mid- and small-cap stocks. In debt portfolio, the funds invest in call money, tri-party repos (TREPs), commercial papers (CPs), certificates of deposit (CDs), Treasury Bills (T-Bills), corporate non-convertible debentures (NCDs), PSU bonds and government securities (G-Secs).

Understand the risk

Hybrid funds are susceptible to the risks associated with equity and fixed-income securities. Since most hybrid funds hold a portfolio heavy on fixed-income instruments, one should understand the risk associated with investments in bonds, especially credit risk. Over the past 15-18 months, a spate of corporate bond downgrades and defaults has impacted the performance of hybrid funds, too.

Bonds issued by IL&FS, DHFL, Essel Group, Altico Capital and Reliance ADAG were all downgraded sharply. This led to mutual fund companies marking down such distressed assets in the portfolio of the schemes that held them. This resulted in significant drops in their NAV. Some debt funds registered around 50 per cent negative returns in a single day.

Of the 129 open-ended hybrid schemes, 37 were hit by such downgrades and defaults of the bonds they held.

Taxation

Hybrid funds that allocate at least 65 per cent of their corpus to domestic equity are treated as equity funds for tax purposes. Aggressive hybrid, balanced advantage, multi-asset allocation (barring a few schemes), equity savings and arbitrage funds fall in this basket. For equity funds, a holding period of 12 months or more is regarded as long-term, wherein long-term capital gains (LTCG) in excess of ₹1 lakh is taxable at the rate of 10 per cent. If the units are redeemed before 12 months, there is a 15 per cent tax on short-term capital gains (STCG) on equity funds.

In the case of non-equity funds, a holding period of 36 months or more is regarded as long-term, wherein the LTCG tax is levied at 20 per cent with indexation benefit on the gain. A holding period of less than 36 months is defined as short-term, and STCG tax is charged as per the investor’s tax slab. Conservative hybrid funds are considered as non-equity funds for tax purpose.

Aggressive hybrid funds

There are 33 schemes under the category, allocating 65-80 per cent of their total assets to equities, while the rest is invested in debt and money market instruments.

Investment strategy: These funds follow a disciplined approach of allocating between equity and debt. This helps them capitalise on opportunities in equity market while giving stability to the portfolio through debt investment.

The schemes under this category depreciate less during market corrections and appreciate less during rallies in comparison to other equity-oriented categories. Lower volatility results in delivering superior risk-adjusted returns than equity-oriented categories over the long term.

Portfolio: During market rallies, many schemes under this category increase their allocations to equity to more than 80 per cent which helps them deliver higher returns similar to that of equity-oriented schemes.

In the equity portion, most of the schemes follow a multi-cap approach, though there is a tilt towards large-cap stocks. The schemes try to capitalise from both accrual and duration opportunities by investing in money market instruments, PSU and corporate bonds and G-Secs. NAVs of 14 out of the 33 schemes under the category were hit by the bond-rating downgrades and defaults in the recent bonds fiasco.

Performance: Performance of these funds depend on how they fare during various cycles of equity and debt markets. Five-year rolling returns data calculated from the past seven years’ NAV history show that the top-10 performing funds under this category have delivered 15 per cent CAGR, which was higher than that of the Nifty 50 TRI (12.7 per cent).

Suitability: These funds are suitable for investors with a medium risk profile who want allocation into equity as well as debt in their portfolio. Investors who are new to equity market and want to taste equity risk can also consider investing in these funds. The ideal holding period is five years and more.

Funds to consider: ICICI Prudential Equity & Debt, SBI Equity Hybrid and L&T Hybrid Equity Fund

Balanced advantage or Dynamic asset allocation funds

Currently, 21 funds are under this category, dynamically allocating between equity and debt based on equity-market conditions. Though this category was introduced post the recategorisation of mutual funds in mid-2018, seven funds, including ICICI Prudential Balanced Advantage and Aditya Birla Sun Life Balanced Advantage, have been following this strategy for more than six years.

Investment strategy: These funds increase their allocation to equities when the equity markets look under-priced, and vice-versa. Each fund follows an in-house valuation model to determine their equity allocation. These valuation metrics use various quantitative criteria such as price-to-earnings (P/E), price-to-book (P/B) or dividend yields.

Portfolio: The equity portion of the portfolio is always maintained at above 65 per cent (barring UTI ULIP); hence, they are treated as equity funds for tax purposes.

Most of these funds follow a hedging strategy by taking equity derivative positions when the equity market valuation appears high. This helps limit the downside while maintaining the equity allocation at above 65 per cent. The allocation to equity shares (unhedged) is 30-80 per cent in most funds. The debt portion is managed with a blend of accrual strategy and duration play.

Performance: In the risk-return pyramid, the balanced advantage category is placed between aggressive hybrid and equity savings funds. One cannot compare balanced advantage funds with aggressive hybrid funds as the latter allocates 65-80 per cent to equity (unhedged). Hence, the participation of balanced advantage funds in equity rallies is limited.

Performance, as measured by five-year rolling returns, shows that the top-five performing funds under this category have delivered 12.5 per cent CAGR over the past seven-year period, which was almost similar to that of the Nifty 50 TRI (12.7 per cent).

Suitability: Investors who wish to participate in equity markets with a relatively conservative approach can invest in this category. The ideal holding period is five years and more.

Funds to consider: ICICI Prudential Balanced Advantage, Invesco India Dynamic Equity and Aditya Birla SL Balanced Advantage.

Multi-asset allocation funds

There are seven funds under this newly introduced category that are mandated to invest at least 10 per cent each in three asset classes — equity, debt and gold.

Investment strategy: This asset allocation strategy aims to reduce the volatility of the returns by investing in asset classes that are negatively correlated. Apart from equity and debt, the investment in gold offers a hedge against market uncertainties and inflation.

Portfolio: Currently, five schemes — Axis Triple Advantage, Essel 3 in 1, HDFC Multi-Asset, ICICI Prudential Multi-Asset and UTI Multi Asset — allocate more than 65 per cent of their corpus to equity and are hence eligible for taxation similar to that of equity funds.

All the funds in the category have an exposure of 10-30 per cent to gold through gold exchange-traded funds (ETFs) or direct investment or both. Funds that currently have higher exposure to gold are Quant Multi Asset (31 per cent), HDFC Multi-Asset (16 per cent) and SBI Multi Asset Allocation (16 per cent).

Performance: All the funds in this category have a short NAV history of little more than a year post the change in attributes. Over the past year, Axis Triple Advantage has outperformed others with a huge margin, by delivering a CAGR of 22 per cent, thanks to its prudent equity stock picking. All the schemes benefited from the recent rally seen in the price of gold.

Suitability : Investors with a medium risk profile wishing to invest across multiple asset classes can consider investing in these schemes with an investment horizon of five years or above. However, considering their short NAV history, one can wait till the funds prove their mettle.

Funds to consider: Axis Triple Advantage, ICICI Prudential Multi-Asset and UTI Multi Asset Fund.

Equity savings funds

The 23 funds under this category currently allocate at least 65 per cent of their corpus to hedged and unhedged equities, and the rest to debt assets. These funds were either launched in the past six years or converted from existing schemes.

Investment strategy: Equity saving funds invest in equities, debt and arbitrage opportunities. While equity provides a kicker to returns, debt offers stable returns with low volatility. The arbitrage strategy is used to take advantage of the price differentials in various market segments such as cash and futures market. Actively using derivatives helps the funds to not only reduce the volatility of returns but also earn some extra returns.

In equity savings funds, there is a good chunk of unhedged equity that can help boost returns. As the equity and the derivative exposure is considered as ‘equity’ allocation, these funds fit the criterion of an equity fund, since at least 65 per cent of their corpus is invested in hedged and unhedged equity. Hence, they are treated as equity funds for tax purposes.

Portfolio : These schemes try to capitalise on arbitrage strategy by allocating 25-75 per cent to arbitrage trades based on the market condition. As per the latest portfolio (September 2019), the top-performing schemes maintained 30-40 per cent in unhedged equity. In the debt portfolio, the funds invest in a mix of AAA, AA and A rated corporate debt and G-Secs. Four funds were impacted by the bond downgrades and defaults.

Performance : In the risk-return pyramid, the category is placed between balanced advantage and conservative hybrid funds. Performance, as measured by three-year rolling returns, shows that the top-five performing funds under this category have delivered 8.7 per cent CAGR over the past five-year period.

Suitability: Equity savings funds are suitable for investors looking for some exposure to equity but have a lower risk appetite. The ideal holding period would be 3-5 years.

Funds to consider: HDFC Equity Savings, Kotak Equity Savings and Edelweiss Equity Savings

Conservative hybrid funds

There are 21 funds under this category, allocating 10-25 per cent to equity and the rest to debt instruments. Earlier, they were categorised as monthly income plans (MIPs).

Investment strategy: Conservative hybrid funds invest as high as 90 per cent in debt instruments and the rest in equity. The higher allocation to debt helps in steady growth of principal with minimal risk. The equity component, on the other hand, helps boost returns.

Portfolio: On the fixed-income side, all the funds have invested in a mix of government securities, corporate bonds and short-term debt papers. They actively manage their debt portfolio based on the underlying interest-rate view. However, considering the current uncertain interest-rate scenario, many funds now follow the accrual strategy. Twelve out of the 21 funds in the category were hit by the rating downgrades and defaults of the bonds they held. The equity portion is managed with a multi-cap approach with a blend of large- and mid-cap stocks.

Performance: Performance, as measured by five-year rolling returns, shows that the top-five performing funds under this category have delivered 10.5 per cent CAGR over the past seven-year period. This is higher than the rates of 5-7.5 per cent offered by bank fixed deposits.

Suitability: Given the higher allocation to debt which is actively managed, these funds are suitable for all types of investors with varying risk profiles. For instance, investors with a high risk appetite can consider allocating a part of their investment if they want to diversify into debt assets instead of investing directly in debt securities or debt schemes. The ideal holding period would be five years or more.

Funds to consider: ICICI Prudential Regular Savings, Aditya Birla Sun Life Regular Savings and SBI Debt Hybrid.

Arbitrage funds

Currently 24 funds are under this category, aiming to capitalise on the arbitrage opportunities available in the cash and derivative segments.

Investment strategy: These funds generate returns through the arbitrage opportunities arising out of pricing mismatch in a security between different markets or as a result of special situations. The risk in these funds is therefore relatively low, similar to liquid funds. These schemes also invest in short-term debt and money market securities.

Arbitrage funds have been gaining the attention of investors of late due to the recent instances of credit downgrades and defaults impacting the sentiment towards some debt mutual funds, including liquid funds. Also, arbitrage funds are treated as equity funds for taxation purposes.

Performance : The returns generated by arbitrage funds depend on the volatility in the equity market and the prevailing short-term rates in the money market. When there is a bullish sentiment and an upward-trending equity market, arbitrage funds typically give good returns. The spread (difference between the price in the cash and the futures market) is determined by the interest-rate levels in the system and the level of activity in the cash and futures market. If the interest rates are low, arbitrage spreads also will be low, and vice-versa. One fund was impacted by the bond default.

One-year rolling return data calculated from the last five years’ NAV history show that the top-10 performing funds under this category have delivered 7 per cent CAGR.

Suitability: It is tax-efficiency that makes arbitrage funds a superior option to liquid and other short-term debt funds. Arbitrage funds are well-suited for investors in the 20 per cent or 30 per cent tax bracket looking for a safe 6-12-month parking ground.

Funds to consider: Nippon India Arbitrage, IDFC Arbitrage and Kotak Equity Arbitrage Fund.