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. Of course, balanced funds are hardly anything new for the Indian investor. For a long time, balanced funds of one sort or another have been offered by fund houses —including the old Unit Trust's original Unit Scheme 64.
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. The combination of debt and equity meant that a well-managed balanced fund would rise less than the equity market on the way up and then fall less than them on the way down. All in all, they were a nice way to capture some of equity's gains without having to face all of its volatility. While this basic character remains the same, balanced funds have evolved in a subtle but important way.
However, as the tax laws evolved to allow long-term equity holdings to be free of capital gains tax, fund companies have upped the amount of equity holdings to qualify for this tax-break. This means that now, these funds must maintain at least 65% of their holdings in equities. In practice, since 65% is the floor, many funds are generally in the 70 - 75% range. At this level, they aren't too far from the asset mix that many equity funds have. This has transformed a balanced fund from a conservative fund to a performance-driven one. This has also been driven by the strategy followed by the dominant balanced fund, HDFC Prudence. A combination of tax laws and its 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 balanced funds.
Interestingly, this has made balanced funds suitable for a broader audience than they were earlier. 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-versus debt allocation has worked to enhance their returns. Rebalancing is an inherent aspect of the way balanced funds are run as the equity and debt percentages have to be maintained at a specific level. In effect, they keep booking profits and thus stay geared for the natural reversion-to-mean that periodically happens between equity and debt returns. The deep swings that the equity markets have undergone in recent years have added to the performance boost that asset rebalancing provides. 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. Normally, any fixed income investments — not just in funds but in any instrument — is taxable. In fact, this tax-efficiency itself 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.
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.
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