Balanced funds are the best way for mutual fund investors to experience the returns of equity investing, but with lower risk than in full-blown equity funds. Smart investors have been using hybrid funds in an ever-increasing proportion, with such funds now totalling to 34 percent of equity funds, up from 24 per cent in just one year. However, in recent months, balanced funds are increasingly being put to a new use, which is as a source of regular dividend.
While this change is being driven by a high pressure sales effort from fund companies and their distributors, investors are receptive to the idea because of the sharp decline in the interest rates available on bank fixed deposits. Those who were earlier wary of investing in funds with any significant equity exposure have been won over by the push from paltry fixed deposit income and the pull from regular dividends. However, a number more knowledgeable fund investors are questioning this kind of investing. After all, putting a lump sum into an equity heavy fund and then treating it like a source of regular income is hardly the kind of practice that is a standard recommendation for fund investing. So what should investors do?
Is this a good way to derive a regular income from a balanced fund? Let's have a little refresher on what are balanced funds and why do they have this name. These funds combine equity and debt investments in a certain ratio. In order to maintain this ratio, the fund manager will typically sell holdings that have gained more and invest in holdings that have gained less. This effectively protects a certain proportion of equity gains by converting them to safe debt investments. When the equity markets hit bad times, such funds fall less than all-equity funds. Of course, during good times, they rise less as well. All in all, they are conservative versions of equity funds, which is fine for a conservative investor who is looking for a regular income.
That's the theory. In practice, there are both pros and cons when balanced funds are used for income. The pros are many. In a deposit, the interest is paid out and the principal stays the same. In a balanced fund, the dividend paid out is slightly less than the gains. The result is a better outcome for investors. For example, let's examine an investment of Rs 10 lakh, made three years ago in a typical balanced fund. During this period, the investor would have received Rs 2.5 lakh as dividend, while the residual amount would also have grown to Rs 12.04 lakh. This combination of a higher income than deposits PLUS a higher withdrawal value than deposits looks unbeatable. On top of that, the dividend income from the fund is entirely tax free. Not just that the residual value can also be withdrawn without any tax liability. Of course, this tax bonanza is not unique to balanced funds, it's available in all equity funds as well. This is another huge advantage over deposits.
That's the plus side, what about the negatives. The main one--actually, the only one--is that at the end of the day, this is an equity-heavy fund. If the equity markets suffer a big reversal, then a chunk of this investment is going to get eaten away. If the investment is a few years old by that time, then the investor will probably be comforted by the dividend already received and the increase in value. The residual value will probably not fall below the invested amount.
However, such a hit can take place soon after investment as well. The only antidote to that is to not invest in a lump sum in the first place. Like all equity-heavy funds, balanced funds should be entered through a steady SIP or STP, at least over a year or so. By all accounts, that not the way they are being sold now. Investing a large amount in one go is a strict no-no for such funds. It may have worked out fine for a while but at some point of time, there will be investments that will lose a good proportion of their value soon after investment.
As long as investors can avoid that fate by using an SIP or STP, using a balanced fund for regular income is a pretty good idea.
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