Indian equity indices are scaling new highs despite stagnant corporate earnings and subdued macro-economic indicators. With major indices like SENSEX, NIFTY 50, BSE Midcap and BSE SmallCap trading at PE multiples of over 22, 24, 31 and 73 respectively, many mutual fund investors are refraining from fresh investments, fearing a major correction.
Timing investments is never an easy task. For those who don't want to miss the current rally and yet are concerned about the current market valuations, investing in balanced funds could be a better option. Here's why:
Balanced fund, as the name suggests, aims to balance your risk-reward ratio by investing in both equity and debt instruments. While its equity component is aimed at generating capital appreciation, its debt component shields the investment from steep market corrections. Thus, the presence of both equity and debt components makes it easier to cope with market volatility.
A cautious investor looking for an inflation-beating regular income can opt for debt-oriented balanced funds as 75–85% of their portfolio is invested in debt securities. Similarly, equity-oriented debt funds will suit those with moderate risk. These funds usually increase their equity exposure up to 80% to exploit low market valuations and reduce it to 65% to contain the downside risk from over-valued markets.
Invest in balanced advantage funds for higher post-tax returns
Another alternative is to invest in balanced advantage funds, which use derivative hedging strategies to contain the downside risks of their equity portfolio. As derivatives are treated as equity holdings, these funds continue to be treated as equity instruments even when their actual exposure to stocks reaches well below 65%.
Automatic asset allocation
Asset allocation is the process of allocating your investments across various asset classes according to your risk profile and investment horizon. Generally, mutual fund investors do this on their own by investing separately in equity, debt or gold funds and then, rebalance their portfolio according to the changing market conditions, risk profile and investment horizon. However, analysing the changes in market conditions is not easy. Such frequent rebalancing may also increase your investment cost in the form of exit loads and short term capital gains tax.
Balanced funds solve this problem by letting you outsource your decision-making process regarding asset-allocation to fund managers. Thus, balanced funds not only save you from the complicated task of asset allocation process, they also help reduce the costs associated with rebalancing your portfolio.
Higher returns than large-cap funds
Despite carrying much lower risk, equity-oriented balanced schemes have been able to consistently match large cap funds in terms of returns. For example, while large cap fund category have generated around 20%, 11% and 15% annualised returns over the last 1-year, 3-year and 5-year periods respectively, equity-oriented balanced funds have matched them with 17% p.a. returns over the last 1-year period and clocked higher returns of 14% p.a. and 16% p.a. over the 3-year and 5-year periods, respectively. This is when equity-oriented balanced funds have a standard deviation, a measure of volatility, of 10.04 while large cap funds have a much higher standard deviation of 13.67.
Thus, under the current market conditions, a cautious investor with a lower risk appetite can invest in equity-oriented balanced funds and earn returns similar to large-cap funds at a much lower risk.
All mutual funds with equity exposure of 65% or more are treated as equity instruments for taxation purpose. Thus, the short term capital gains, i.e. gains booked within 1 year, of equity-oriented balanced funds are taxed at 15% while their long term capital gains are tax-exempt. As such funds are treated at par with equity funds in terms of taxation, investors worried about high market valuations can invest in these funds without fearing any adverse effect on their taxation front.
As debt-oriented balanced funds are treated as non-equity instruments, their tax treatment is similar to pure debt funds. Thus, their short term capital gains are added to your income and taxed according to your tax bracket while their long term capital gains, i.e. gains booked after 3 years, are taxed at 20% with indexation and at 10% without indexation. As the equity component in these funds enable them to generate higher returns than fixed deposits and pure debt funds, these funds will suit conservative investors seeking higher returns on their investments with time horizon of less than 3 years.
Comparison of annual returns and standard deviation of large cap and equity-oriented balanced funds
Mutual funds category
Large cap funds
Equity-oriented balanced funds
(Manish Kothari is the Head of Mutual Funds, Paisabazaar.com)