Are balanced funds falling out of favour?

Balanced funds received inflows of Rs 3,500 crore in April 2018. This was less than half of the Rs 7,136 crore they got in April 2017. This was also a steep decline from the Rs 6,754 crore they got last month.

Why this may be happening

Rising interest rates have inflicted major pain on the debt components of balanced funds. The prices of debt (bonds) usually fall when interest rates rise. Equity-oriented hybrid funds (popularly called balanced funds) typically invested 0-35% of their assets in debt. This was meant to be a cushion against volatility in equities. However, it is the ‘cushion’ that has been a drag on fund returns rather than the other way around. Their equity picks have also turned out to be less promising than expected. As the figures below show, some funds like HDFC Prudence have fared worse than others, but in all cases, the one year return has dipped below the three-year annualized return.

Figures as observed on 15th May 2018, Source – Value Research

The ongoing re-categorisation of mutual fund schemes has added an element of confusion to how this is going to pan out. Our analysis shows that the vast majority of large balanced funds have classified themselves as ‘aggressive hybrid funds’ rather than ‘balanced funds.’

Under the new SEBI classification system, whilst ‘balanced funds’ must invest 40-60% of their assets in equities, ‘aggressive hybrid funds’ must invest 65-80% of their assets in equities. This ensures that these funds remain equity funds for tax purposes but also exposes them heavily to the risk of equities.

Equity funds face a 15% tax for holding periods of less than one year and a 10% tax for longer holding periods (with an annual tax-exempt allowance of Rs 1 lakh). Gains made before 31st Jan 2018 have been exempted. Non-equity funds, on the other hand, are taxed at slab rate (which could be 30%) for holding periods of less than three years and thereafter at 20% with indexation.

A few schemes adopted the ‘dynamic asset allocation/balanced advantage’ category. In this category, there is no percentage split between the equity and debt allocation. The split is decided by the fund manager according to his outlook on the equity and debt markets. Prominent among funds embracing this category are HDFC Prudence and ICICI Pru Balanced Advantage. Here, the formal guarantee of equity tax status is lost but the fund manager gets the flexibility to move fully between equity and debt.

RupeeIQ Take

It is difficult to predict how balanced funds will perform in the future. Interest rates are expected to rise further and take a toll on fund returns. Equity markets are also losing steam.

The word ‘balanced’ also needs to be understood correctly. The SEBI ‘balanced category’ imposes a 40-60% range on equity allocation, meaning such funds will be considered ‘debt’ for tax purposes and face a different tax treatment. As shown above, most existing balanced funds have opted for the ‘aggressive hybrid fund category’, which ensures the equity tax status but reduces the fund manager’s flexibility of moving into debt. You also have the third ‘balanced advantage’ category which gives greater flexibility to the fund manager. You can consider the latter category if you are more worried about safety than taxation and have a high level of confidence in the fund manager.

In any case, check the SEBI category before investing.