4 min read.Updated: 03 Sep 2019, 11:17 PM ISTNeil Borate
The freedom to switch between equity and debt hasn’t helped these funds
Fund managers failed to move into debt and protect investors as equity markets floundered over the past year
Unlike most categories laid out by the capital markets regulator, the Securities and Exchange Board of India, balanced advantage or dynamic asset allocation is a go-anywhere mutual fund category. In theory, these schemes can move completely into debt when markets get overvalued and vice-versa, with no restrictions. The scheme information documents of some funds impose limits but these are extremely liberal. The idea is that lack of constraints will allow the fund manager to take asset allocation calls and give good returns regardless of market movements. But has this been the case? Unfortunately not.
Balanced advantage funds come with the advantage of moving between equity and debt. In addition, they are also marketed as having lower risk than pure equity funds, but with the potential to give higher returns than pure debt funds while being classified as equity funds for tax purposes.
The argument is that these funds can use futures and options (hedging) to reduce equity exposure to 30-50% or even lower while maintaining a gross equity exposure above 65%, which allows them to be taxed as equity funds. Some hybrid funds like balanced hybrid funds and conservative hybrid funds can also have low equity exposure but they have to operate within the Sebi-specified constraints. Balanced hybrid funds have to keep 40-60% of their assets in equity, and conservative hybrid funds (erstwhile monthly income plans) have to maintain a 10-25% exposure to equity. The two categories are taxed as debt funds, so you pay tax at your slab rate for holding periods of less than three years, which can be 30% at the highest tax slab. For longer periods, the tax rate is 20% with indexation. Equity fund taxation, on the other hand, means a 15% tax for gains within a one-year holding period and 10% thereafter with a ₹1 lakh tax-free capital gains limit per year.
Balanced advantage funds are close in structure to equity savings funds. The key difference is that equity savings funds must specify how much equity exposure they can hedge, bringing some rigidity.
The balanced advantage category is dominated by HDFC Balanced Advantage and ICICI Prudential Balanced Advantage. The two schemes have assets under management (AUM) of ₹41,472 crore and ₹27,798 crore, respectively, as of 31 July 2019. There is a long tail of smaller schemes in this category with AUMs barely one-tenth of the two mentioned above, and many of these were launched in the last one to two years.
HDFC Balanced Advantage fund was formed by a merger of the erstwhile HDFC Prudence and HDFC Growth funds. It has a high unhedged equity exposure (nearly 82%) and keeps this relatively stable rather than using arbitrage to adjust it as per market valuations. This makes this fund a lot more riskier than its peers. However, it can also give higher returns due to the higher equity portion.
ICICI Prudential Balanced Advantage fund uses a price-to-book model to decide on asset allocation rather than fund manager discretion. This scheme uses hedging to deliver equity taxation but the resultant allocation gives a slightly lower return than a plain vanilla equity-debt hybrid. “The arbitrage component of the fund does not generate the same returns as debt and hence one cannot expect a return comparable to debt when equity markets are down, if the balanced advantage fund is using arbitrage. However, it does much better than a pure equity fund at such times," said Sankaran Naren, executive director and chief investment officer, ICICI Prudential Asset Management Co.
Remember that although hedging can protect downside during market corrections, it can also limit your upside when markets move higher.
One way to evaluate this category is to look at the performance of the top five funds which dominate in terms of the AUM. These funds delivered 0.79% on average with the top fund delivering 3.84% over the past year. In other words, the fund managers failed to move strongly into debt and protect investors as equity markets floundered over the past year. The past three-year returns stand at 7.22% and 8.15% over the past five years, which essentially means that the returns were similar to what bank fixed deposits or a short-term debt funds give.
Balanced advantage funds are taxed as equity but the advantage of equity falls away as indexation kicks in for debt funds despite the higher 20% tax rate. In other words, the tax advantage of using arbitrage doesn’t work well for time periods longer than three years.
“Investors who have entered for a less risky equity substitute are better off than they would’ve been had they invested in equity funds. Those who came in for a debt substitute, especially on the assurance of regular income, will be disappointed," said Vishal Dhawan, founder, Plan Ahead Investment Advisors.
Should you invest?
Not all balanced advantage funds use hedging and, hence, you should check the fund’s portfolio first. That said, financial planners have been skeptical of the category. “If you look at the expense ratios of these funds, they’re a lot more than the weighted average expense ratio of equity and debt funds in a similar 50:50 allocation. Also, you don’t have any control on the credit quality of the debt component of these funds," said Dhawan.
Deepali Sen, founder, Srujan Financial Advisors, recommends pure equity or debt funds. “Balanced advantage funds do not fit well into an absolute return bucket. Clients care about absolute returns, not how their fund is doing relative to other categories. For short- and medium-term goals, I recommend pure debt funds and for long-term goals, I recommend pure equity," she said.
A pure debt-equity split may look rigid but it has the advantage of simplicity. It also has comparable tax benefits even with equity less than 65% if held for more than three years. Investors may be better off sticking to simpler hybrid categories such as conservative or aggressive hybrid funds.