Every bull market has its favourites and the hot favourite this time seems to be balanced funds, also known as hybrid aggressive funds. Data from AMFI shows that balanced funds received over Rs 47,000 crore in net inflows during the April to September period last year, compared to annual flows of about Rs 9,000 crore only three years ago.
A good part of those inflows is probably from seasoned investors. For those looking to make equity gains by holding onto their mutual funds for five years or more, balanced funds are indeed great products. They deliver equity-linked wealth creation while automatically rebalancing from equity to debt (or vice versa) at periodic intervals to ensure risk control.
But there are now plenty of uninformed investors piling onto balanced funds as well. Many pensioners and retirees write in to ask if they should listen to their banker, and shift all their money from bank FDs to a balanced fund in order to earn a 'guaranteed' monthly dividend. If balanced funds can offer a 1 per cent tax-free income every month, they argue, why settle for 6.5 per cent for the whole year from a bank FD?
Well, there are two flaws to this argument. One, balanced funds can subject your capital (not just returns) to wild swings in value. As balanced funds invest anywhere between 65 and 80 per cent of their portfolio in stocks, they are only slightly less risky than pure equity funds. This means that you can suffer capital losses on balanced funds if the Sensex tanks.
Looking back at one, three or five-year performance of balanced funds today, the returns look mighty impressive because the BSE Sensex has headed mostly up in the last five years (see Figure 2). But if you rewind to 2011, when the BSE Sensex fell by 25 per cent, the balanced fund category suffered a capital loss of 16 per cent that year. In 2008, the biggest bear year in recent memory, when the BSE Sensex plummeted by 52 per cent, the average balanced fund wiped out 43 per cent of its NAV. If we again have a big bear year like 2011 or 2008, your balanced fund can lose value again. This makes it a really poor substitute for a bank FD, which offers absolute safety of capital.
Two, while bank FDs guarantee interest, balanced funds, even if they have a regular dividend track record, do not guarantee any return. In fact, SEBI forbids all mutual funds from guaranteeing returns because they are market-linked products. Then how have some balanced funds paid a 1 per cent monthly dividend so steadily for the last three years?
Well, to understand how, you need to grasp that the returns on a balanced fund, unlike those on a bank FD, come mainly from the capital appreciation on its equity portfolio. When stock markets rise, balanced funds register capital gains and book profits on some stocks to return that money to you as dividend. The fund's NAV falls to the extent of the dividend paid out. Therefore, the dividend does not really add anything extra to your returns as a balanced-fund investor. Indeed, if the stock market suffers a steep fall or fails to deliver gains for many years, balanced funds can skip monthly dividends or trim them. If they continue to pay dividends in a falling market, it means that it is coming out of your capital.