In the last issue of Wealth Insight we had discussed how your portfolio should be compartmentalised into a core and a satellite portfolio. In this issue we shall discuss a type of fund that can constitute the core of the portfolio.
As discussed in the last issue, the core portfolio serves as the anchor to the entire portfolio. Hence, one of the prerequisites for a fund that can be part of the core portfolio is that it should require minimum maintenance and should be able to adjust to market conditions. We believe hybrid:equity funds, more commonly known as balanced funds, are ideal candidates for constituting the core.
In a hybrid:equity fund, the fund manager balances the fund's equity-debt allocation according to market conditions. This will leave you free to concentrate on the active portion of your portfolio that requires greater attention.
The disadvantage of having balanced funds in the core portfolio is that you cannot specify your equity-debt mix. This will be determined either by the law or by the fund house. A more conservative investor may, for instance, desire a lower allocation to equities, but by just owning balanced funds he will not be able to achieve this.
What is a hybrid:equity fund?
Hybrid:equity funds combine a stock component, a debt component and sometimes a money market component in a single portfolio. They generally stick to a relatively fixed asset allocation.
A hybrid:equity fund is geared toward investors who are looking for a mixture of safety, income and modest capital appreciation. The amount that such a mutual fund invests in each asset class remains within a set minimum and maximum limit. In our case, the hybrid funds we are talking about invest about 65 per cent in equity and 35 per cent in debt and money market instruments.
How balanced funds are different
The objective of these funds is to provide capital growth via a mix of equity and debt:
Blend of growth and safety. The unique proposition of spreading investments among two broad asset classes is hard to find in other types of funds. The higher equity allocation to the tune of 65 per cent gives these funds the opportunity for high growth, while the debt component provides a cushion when the equity component fails to perform. At the same time, the same debt allocation pulls the fund's return lower during a bull run since these funds are not fully invested in equities.
Flexibility. The best hybrid:equity funds keep allocation flexible and open to changes as demanded by market conditions (but subject to regulations). In 2008, when the market tanked by (-)52.44 per cent, funds like JM Balanced drastically reduced their equity allocation from 80.34 per cent (March 2008) to 43.30 per cent (October 2008). The average swing for the category of hybrid:equity funds from equity to debt was 17 percentage points, at par with that for equity-diversified funds. But keep in mind that unlike hybrid:equity funds (which allocate 65 per cent to equities) equity diversified funds generally have 90-100 per cent of their corpus invested in equity.
Low downside risk. Among equity funds, hybrid:equity funds have the lowest downside standard deviation. (see graphic: Lss Standard Deviation). Standard deviation is a measure of volatility. It measures how much the data points are spread out in relation to the mean. Loss SD considers just the downward volatility since we are interested in knowing only the downside risk of hybrid:equity funds in relation to other types of funds.
Advantages
Switching. Their key advantage is the ability to switch from a high equity allocation with more aggressive growth oriented stocks when the market is bullish to low equity allocation with more defensive stocks when the market turns bearish.
Diversification. These funds offer diversification in the true sense with a portfolio that contains stocks and bonds, thereby offering a blend of growth and safety.
Hassle-free. You do not have to take the trouble of managing an assortment of investments yourself. One fund does it all. Your overall cost of owning and managing your investments also comes down.
Disadvantages
Active-management risk. The active-management risk can get amplified in these funds. The fund's exposure to equity or debt is a function of the fund manager's view about the direction of equity markets. A fund having a high exposure to equities during bear runs exposes investors to undue risks while going overweight on debt during bull runs results in a failure to reward investors adequately.
Objective mismatch. A hybrid:equity fund may have bonds of lower tenure while what may ideally suit your portfolio objective is longer-term bonds. Long-term bonds earn significantly more than short-term bonds. Hence instead of complementing your portfolio objective, hybrid:equity funds can potentially act contrary to it.
Tax incidence
Hybrid:equity funds are treated as equity funds according to the income tax department's definition. Currently they are subject to just short-term capital gains tax (at the rate of 15 per cent). Both dividend income and long-term capital gains from hybrid:equity funds are tax-exempt.
The direct tax code (DTC) proposes to modify this. Under the new regime both short-term gains and dividends will be subject to tax. Your short-term gains will be taxed according to your tax slab - 5 per cent, 10 per cent and 15 per cent respectively for the three tax brackets. Dividends will now be subject to a tax of 5 per cent.
The tax rules play to the strengths of hybrid:equity funds. Investors need to rebalance their portfolio at the end of every year to maintain the desired asset allocation. But the short-term capital gains tax will make rebalancing before one year a tax-inefficient strategy.
In hybrid:equity funds, fund managers do the rebalancing. The current tax laws do not have provision for taxing the fund manager's actions. In essence, the fund manager can rebalance the fund's portfolio n-number of times and still attract no tax. Hence, the rate of return of these funds will not get eroded due to rebalancing.
How to buy a hybrid:equity fund
Your first step while selecting this category of funds should be to visit our website valueresearchonline.com and check the ratings of hybrid:equity funds. At valueresearchonline.com, hybrid:equity funds are rated according to their five-year and three-year risk-adjusted returns. So a 5- or 4-star rated fund would mean that over the past five-year and three-year horizons these funds have given the best risk-adjusted returns among hybrid:equity funds.
Remember, however, that rating are quantitative measures. The way one 5-star fund may have generated returns might not suit your risk appetite. Hence you should dig deeper and try to gather more information about the fund. One should look at how active the fund manager has been in asset allocation. Check whether in the process of generating excess return he has allowed equity allocation to go beyond 65 per cent. During the 2007 rally, funds like LICMF Balanced allowed their equity allocation to go as high as 91.11 per cent. This enabled the fund to post a return of 63.93 per cent return, ranking 3rd out of 26 funds in its category. But this approach is contrary to the basic idea behind buying a hybrid:equity fund.
Opt for funds that have shown consistent results. A fund like Escorts Balanced tops the chart during bull runs but finds itself at the bottom of the heap during bear runs. Such funds lack the consistency that is desired in a core portfolio fund.
Finally, find out where the fund manager invests both in the equity and the debt portfolio. Funds like HDFC Balanced and Escorts Balanced invest in mid- and small-cap stocks in their equity portion, while Magnum Balanced and UTI Balanced consistently invest in large-cap stocks. As an investor you need to decide which style suits your portfolio. Also find out where the fund manager puts the money in the debt portion. Funds like DSPBR Balanced invest in floating-rate paper that minimises the interest-rate risk within the debt portfolio.
Category round-up Hybrid funds are categorised by their average equity exposure. Funds which over the last three years have had an average equity allocation of 65 per cent or more are placed within the hybrid:equity funds category. Currently this category has 27 funds. The average annualised return of this fund category over the last five years (ending July 31, 2010) has been 16.23 per cent. The best return of 23.61 per cent for this period was generated by HDFC Prudence while UTI CCP Advantage fetched the least return of 9.08 per cent. Incidentally the biggest fund in the category is HDFC Prudence, which accounts for half the investment in this category. The fund has the second-largest portfolio of 71 stocks, almost double the category average of 38 stocks. On an average, the 20 top stocks (by percentage of assets) of these funds corner 74 per cent of the total equity assets. The most popular stock within this category is Infosys Technologies which is present in 20 out of 27 funds. Bharti Airtel and Larsen & Toubro come next: both of them have been bought by 18 funds. Reliance Regular Savings-Balanced has the highest Sortino Ratio (a measure of risk-adjusted return) of 1.04 while JM Balanced has the least of -0.13. (Sortino ratios have been calculated over a three-year period.) Our Analyst Picks for this category are Birla Sun Life 95, Canara Robeco Balance, DSPBR Balanced, HDFC Prudence and Reliance Regular Savings Balanced.This article was originally published on October 06, 2010.
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