Almost without investors noticing, balanced funds have undergone a gradual but substantial change in their character. This is a change that investors must understand in order to get the right set of benefits from this very useful category of funds.
Once upon a time balanced funds really were balanced. That is, they generally used to have about half of equity and half of debt. This meant that they were a substantially conservative version of equity funds which rose less than the markets on the way up and then fell less than them on the way down. However, as the tax laws evolved to let long-term equity holdings be free of capital gains tax, fund companies have upped the amount of equity holdings to qualify for this tax-break.
This now means that these funds must maintain at least 65 per cent of their holdings in equities. This has transformed balanced funds from a conservative type of fund to a performance-driven one. This has also been driven by the strategy followed by the dominant balanced fund, HDFC Prudence. In effect, a combination of the tax laws and this fund’s aggressive equity posture has meant that balanced funds are now sold to investors as a performance play. Fund marketers find that it’s no use pointing out how their funds fall less than the indices—they have to show how they rise more than the indices, or at least more than other funds.
Added to this are the beneficial side-effects of two other characteristics of balanced funds. One, as the markets have stayed volatile, the automatic rebalancing of these funds equity-vs-debt allocation has worked to enhance their returns. Rebalancing is an inherent aspect of the way balanced funds are run. Because the equity and debt percentages have to be maintained at a specific level, fund managers routinely sell whichever of the two that has gained more and sell the other. In effect, they keep booking profits and gearing for the natural reversion to mean that happens.
Of course, individual investors can do the same but there’s a powerful incentive to do this through a balanced fund—the switching between the two doesn’t attract tax. There’s yet another hidden benefit that’s hardly ever pointed out. The debt part of the holding also becomes effectively tax-free. In fact, this is a huge incentive to hold a good part of whatever fixed income investments you need as part of a balanced fund rather than independently—the gains are tax-free.
All in all, today’s balanced funds may be a little less balanced than those of yore, but they are extremely suitable to be the core of practically any fund investor’s portfolio. This is the ideal gateway product for fund companies and the best way for fund investors to manage gains, asset allocation as well as taxation in their long-term investment.