Should retirees go for balanced funds?

Equity-oriented balanced funds have become the blue-eyed boys lately, raking in ₹38,900 crore in new money in the first five months of FY18, compared to ₹8,500 crore in the same period last year.

These balanced funds are good products for risk-taking investors who don’t mind volatility, but are willing to stay invested for a minimum five years to make equity gains that help meet a long-term goal.

But indications are that balanced funds are aggressively being sold as a regular income vehicle to risk-averse investors - retirees looking to invest their terminal benefits and savers looking for a tax-free substitute to bank FDs. In fact, some investors have even bought balanced funds under the misconception that they ‘guarantee’ a monthly dividend! Here’s why balanced funds are unsuitable for such investors.

Many investors are attracted to balanced funds by their tax-free returns. But those returns come packaged with the biggest risk in equity investing — that of capital losses.

Under Indian tax laws, any fund that invests 65 per cent or more of its portfolio in equities is exempt from dividend tax and capital gains tax as well if held for one year. Most balanced funds therefore invest anywhere between 65 per cent and 75 per cent of their portfolio in equities. With such a high equity allocation, they do suffer capital losses when the stock market tanks.

The five-year record of balanced funds offers no indication of this risk, because none of the last five years was a bear year. But if you rewind to 2011 when the BSE Sensex fell by 24.6 per cent, balanced funds suffered an average capital loss of 14 per cent that year. In 2008, the biggest bear year in recent memory, as the BSE Sensex lost 53 per cent, the average balanced fund lost 37 per cent of its net asset value (NAV).

But won’t the 25-35 per cent debt component cushion losses? They will. But the debt portfolios of balanced funds have also made exceptional gains from falling interest rates in the last five years. With the stock market trading at high valuations and interest rates close to their bottom, both asset classes look set to deliver much lower returns from here.

If we have a big bear year, balanced funds can suffer a loss. This makes them a really poor substitute for a bank FD.

Mutual funds are allowed to pay out dividends only from their realised capital gains. The profit that a fund can make from selling its stocks will vary from year to year depending on market conditions. This is why SEBI forbids mutual funds from guaranteeing any returns.

Balanced funds have seen wide swings in their NAV returns in the last five years. They averaged a gain of 24 per cent in 2012, 7 per cent in 2013 and 36 per cent in 2014, but only a 3 per cent return in 2015 and 6 per cent in 2016. So how did some funds consistently pay double-digit dividends?

Well, this is because, even in a year where its portfolio actually appreciates only by 3 per cent, a fund with a long history may be able to book profits on its older, low-cost investments to ‘realise’ some profit.

But you should take note that, if a balanced fund pays out high dividends in a flat or down year for the stock market, it is only returning a part of the NAV gains you have already made, back to you. All mutual fund dividends are paid out of a fund’s NAV, and your remaining capital in the fund falls to the extent of your dividend.

The big secret to wealth creation from equities is to reap the long-term benefits of compounding by staying put over market cycles.

But when you sign up for the Dividend option of a balanced fund, you are flouting these rules. As the fund manager will sell his stocks for the dividend irrespective of market conditions, you may end up withdrawing money in a bear market and will not be letting it compound.

Taking stock today, the Growth options of balanced funds have averaged three and five-year returns of 12 per cent and 16 per cent. But it is important to bear in mind that those returns are made by Growth option investors who remained invested in the fund. Dividend option investors would be sitting on a much lower return as they are likely to have either spent their dividends or idled them in a bank account. A ‘regular’ double-digit dividend from a balanced fund therefore costs you dear in terms of long-term returns.