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Balanced Funds vs Large-Cap Funds






LET'S TOSS A COIN Despite a better risk-reward profile, balanced funds are not substitutes for large-caps

The stellar performance of balanced funds over the past few years has attracted the attention of investors. Harnessing the return potential of equity and the safety of debt, balanced funds, for many , is the core of their portfolios. These funds have trumped the returns of large-cap equity funds across the three-, five and 10-year time frames. And this higher return has come at a much lower risk. Does this mean that balanced funds are a better bet than large-cap funds? Would investors be better-off replacing their large-cap funds with balanced funds?


Balanced funds have been sold to conservative investors as an ideal product that captures the potential of equities without the accompanying volatility. Balanced funds as a category has clocked a lower


standard deviation--a measure of volatility in fund returns--of 10.98 compared to the large-cap funds category , which has averaged 14.92. Balanced funds have also recorded a higher


Sharpe Ratio--a measure of risk-adjusted returns--of 1.36 compared to 1 of large-cap funds. This suggests balanced funds boast of a much better risk-reward profile.

However, experts counter that many balanced funds do not fit the conservative profile of this catego ry. Some are, in fact, riskier than large-cap funds.

Balanced funds cannot be a replacement for large-cap funds as it is the former's aggressive stance that has contributed to their higher returns. Some balanced fund portfolios have a distinct mid-cap tilt, which lends a higher risk profile to the fund.

The debt portion in a balanced fund masks the fact that many balanced funds today have a mid-cap bias. This makes them favourable for those who want to take on higher risk compared to a pure large-cap fund.

For instance, HDFC Prudence has a standard deviation of 16.6, which is much higher than the basket of large-cap funds. Several funds, even with a lower standard deviation, are exposed to higher volatility in their equity portfolio but it is not visible due to the cushion that the debt portion provides.

Nagpal points out balanced funds often do not have a clear positioning for their equity portion, which makes it difficult to gauge the fund's investing stance.  Some balanced funds do not have a set strategy in their equity allocation. An unconstrained approach to portfolio construction provides little comfort when the product is meant for a conservative investor.

Some funds also take on higher risk inadvertently , when taking individual stock exposure. All equity funds, including balanced funds, are mandated to restrict exposure to individual stocks to 10% of the portfolio. But when a balanced fund takes high exposure to a stock within its equity allocation, it is effectively taking a higher risk for its entire portfolio (including debt portion).

Another reason for the popularity of balanced funds is their tax-efficiency . Debt funds on their own are not tax-friendly, as one must hold them for at least three years before the capital gains can be treated as long-term, and be eligible for lower tax. Gains from equity funds on the other hand are tax-free after a year of holding. Equity-oriented balanced funds, recognised as equity funds for tax purposes, effectively let investors enjoy gains in the debt portion without incurring tax.

Despite their tax efficiency , Shah feels investors can do better by handling the equity and debt portion separately . "One can handle asset allocation better by having separate funds for the two asset classes. A balanced fund rebalances within a very nar row band. Besides, a debt fund comes at a much lower expense ratio compared to a balanced fund.


Investors must understand the circumstances in which balanced funds have delivered stellar returns.


The cycle of falling interest rates over the past few years has improved the returns from the debt p o r t i o n o f b a l a n c e d f u n d s.Combined with the healthy stock market returns, the overall performance has got a twin boost. This will not sustain going forward as interest rates are nearing the end of the softening cycle.


This will hurt the debt portion of balanced funds, most of which is invested in long-duration government securities that are most sensitive to interest rate changes. The constrained equity exposure may limit balanced funds' performance vis-a-vis large-cap funds going ahead. With the economy set to kick into higher gear, the stock market is likely to outperform in the coming years. It would make more sense to be invested in a 100% equity product than one which only provides around 70% exposure.


Since balanced funds do not let the gains in stock investments run beyond a point to keep equity exposure within a band, it limits the potential of gains from a rising market.






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