Balanced Advantage Mutual Funds Risk VS Returns

After a dream run of year 2017, Indian equity markets are currently facing a reality check. Since the start of this year, we have been witnessing a rise in volatility in the equity markets. Moreover, we do not see this volatility waning away in a hurry due to various domestic and international factors. The lack of any definite direction has led to markets moving sideways. Apart from the equity markets, the bond market is also witnessing its bout of volatility with a downward bias.

When both the major asset classes are showing signs of volatility, investment becomes tricky. Therefore, most of the experts believe that investors can use balanced advantage funds to ride this period of uncertainty. Balanced advantage fund (BAF) come under the hybrid scheme as per SEBI’s new categorisation rule and are funds that invest in both equity and debt in varying proportion. The proportion decides the type of hybrid funds and how it is going to be taxed (Check: Types of hybrid funds and taxation). The ratio between different asset classes is managed dynamically. This gives the fund manager the flexibility to allocate assets according to the market condition. Therefore, the fund manager can increase or decrease the equity allocation to the entire portfolio as per his understanding of the market and a process that has been pre-defined to rebalance the portfolio.

For example, in the current situation when the equity market is trading at rich valuation, the fund manager can reduce the exposure of the portfolio to the equity. Going forward if the market corrects or earnings improve better than expected both of which will ultimately lead to attractive valuation of equity, fund manager can increase exposure to equities. The same strategy can be applied to the debt part of the investment, however, most of the funds use debt for stable returns and downward protection. This gives an investor best of both the worlds. However, to qualify for equity taxation benefits, equity plus arbitrage component of the scheme should be at least 65 per cent of the corpus. 

To understand the pattern of performance of the BAF in different market cycles, we analysed the returns of all the BAF schemes since the start of FY09. We studied only those hybrid funds that are equity-oriented, where the equity allocation is more than 65%. 

We studied the data of monthly returns since the start of FY09 to find how BAF performed during different market conditions. If you had invested Rs 100 at the start of financial year of 2009 in pure equity funds, your money would have become Rs 305.08 by the end of March 2018 giving an annualised return of 11.8%. The same Rs 100 invested in equity-dedicated balanced funds (assuming average category returns) would have become Rs 325.6 during the same period, giving an annualised return of 12.53%. The difference of 0.73 per cent per annum is quite high and is reflected in the growth of the corpus. 

But, as they say, the devil lies in the detail. One of the reasons for such outperformance of the BAFs in the long run is their ability to contain the losses or restrict the fall in the value of the fund. When the equity market is rising, these funds may not rise in the same proportion; however, when equity market falls, they do not fall by the same percentage. Therefore, they must recoup lower losses to attain the same level of growth as compared to equity funds. For example, if your fund has fallen by 20 %, the fund needs to gain 25% to reach to the original level. However, if your fund has fallen by 10%, it needs to recover only 11.11% to reach the break-even level. Hence, the protection from fall helps them to outperform in the long run.

This is even reflected in our analysis of returns of BAFs and a frontline index like Sensex. We assumed Sensex returns as representing returns of pure equity fund. Out of all the monthly returns that we analysed, 48 per cent of the time the average return of the BAFs have outperformed the equity indices, while in 52% cases these have underperformed. The interesting part to note is that every time the frontline indices have given negative monthly returns, BAFs have outperformed them. The reason being BAFs hold debt in the portfolio, which are likely to remain immune from the fall in the equity market. 

Prior to the SEBI norms on categorisation of mutual funds, there were only two kinds of hybrid funds; one was equityoriented fund, where majority of the assets were held in equity. 

Another was debt-oriented funds, where bonds were held in majority. Nevertheless, the SEBI circular on categorisation of mutual funds has proposed six categories of hybrid funds.

Conservative Hybrid Funds 

These schemes will invest 75 to 90 per cent of their total assets in debt instruments.These schemes can also invest around 10 to 25 per cent in equity-related instruments. These schemes are called conservative because they invest predominantly in debt instruments.

Balanced Hybrid Funds and Aggressive Hybrid Funds

Balanced hybrid funds will invest around 40 to 60 per cent of their total assets in either equity or debt instruments. These schemes cannot invest in arbitrage.

Aggressive hybrid funds will invest around 65 to 85 per cent of their total assets in equity-related instruments. They can also invest around 20 to 35 per cent of their assets in debt instruments. 

Mutual fund houses can offer only one of these two categories, either a balanced hybrid or an aggressive hybrid fund.

These schemes will make investments in equity and debt, which is managed dynamically.

These schemes should at least invest in three asset classes. These schemes should invest a minimum of 10 per cent in each of the asset classes. Foreign securities will not be treated as a separate asset class. 

These schemes will follow arbitrage strategy and will invest a minimum 65 per cent of total assets in equities or equity-related instruments. 

These schemes will invest in equity, debt and arbitrage. They will have to invest at least 65 per cent of the total assets in stocks and a minimum 10 per cent in debt. These funds would declare the minimum hedged and unhedged investments in the scheme information document (SID). 

 Long term capital gains tax @10% (plus surcharge, if applicable and cess) without indexation if units are held for more than 12 months 

 Short term capital gains tax @15% (plus surcharge, if applicable and cess) if units are held for less than 12 months 

 Investor does not pay any tax on the dividends but a Dividend Distribution Tax (DDT) is deducted at source @11.648% (10% + 12% surcharge + 4% health & education cess) 

S Naren 

ED & CIO, ICICI Prudential AMC

 

"BAF aids an investor to buy low and sell high through a model-based approach"

Do you think it’s the right time to invest in Balanced Advantage funds? 

We have been encouraging investors to opt for balanced advantage category of funds given its ability to limit downside risk in a falling market, while aiming to capture the upside in a rising market. This is because we believe the markets are likely to remain volatile over the next 18 months owing to a variety of developments in global and domestic markets. In such a situation, the balanced advantage category of fund emerges as the optimal investment option (especially lump sum) given the fund’s ability to dynamically allocate assets (equity and debt) based on relative market conditions, i.e. the scheme allocates higher in equity when the equity market valuation is low and lower when the equity market valuation is high. The net equity level of ICICI Prudential Balanced Advantage Fund can move between 30-80% on the basis of the in-house model followed. 

The equity segment of Balanced Advantage Fund currently has a bias towards large-caps and structurally strong companies which have demonstrated track record over time. As on May 31, 2018, the net equity exposure of the scheme stands at ~37% as against ~33% in the previous month. This is based on valuations, along with the macroeconomic parameters incorporated in the model.

In terms of stock selection, the scheme is a blend of large-cap and mid-cap stocks. While the large-cap stocks represent established enterprises selected from the Top 100 stocks by market capitalisation, the mid-caps and small-caps represent business entities with long-term growth potential. The allocation is decided on a tactical basis, rather than any predefined ratio. The scheme uses derivative instruments for the purpose of hedging or portfolio rebalancing or for any other stock and/or index strategies as allowed under SEBI regulations. 

The debt portion is dynamically managed to exploit the various opportunities available in the debt market from time-to-time. The debt exposure as on May 31, 2018 stands at ~32%. Within the debt holdings, the scheme has a higher exposure towards good credit quality instruments to benefit from higher carry. 

The scheme uses an in-house asset allocation model to maintain an effective equity investment. Based on the model, the allocation towards equity and debt is determined on an ongoing basis. 

An investor’s main goal when investing into equities should be to protect the potential downside risks during market corrections, and this is what the balanced advantage category of scheme does. Such type of fund aids an investor to buy low and sell high, through a model-based approach, such that the investor has a good investor experience over a period of time. 

Here, the fund manager shifts exposure between equity and debt based on the basis of a predefined valuation model by reducing positions in the best-performing asset class and adding in underperforming assets. Such an arrangement ensures that the investor gets the opportunity to participate in the market upside, while in case of a market correction, the presence of debt component ensures that the downside is protected. 

Additionally, such an arrangement is superior to investing individually in equity and debt on two counts for a retail investor. 

1) Such funds save an investor's time and energy in actively tracking the market and constantly making changes to one's asset allocation
2) When rebalancing the portfolio, one may end up attracting tax incidences. 

Manish Gunwani 

CIO-Equity, Reliance Nippon Asset Management 

"BAF can be included as part of core investment portfolio of an investor"

Do you think it’s the right time to invest in Balanced Advantage funds? 

Reliance Balanced Advantage Fund seeks to generate superior volatility-adjusted returns by dynamically managing the equity allocations based on prevailing market conditions and future outlook. The product is designed to automatically adjust the equity component with an attempt to lower the downside risk, while providing a reasonable upside participation to capture the market uptrends. Thus, given the in-built product feature of better volatility-adjusted returns, investors with appropriate risk appetite can consider the investments across market phases. 

For the equity part, the investment universe of the fund would be primarily top 200 companies by market capitalisation. The fund would have a large-cap orientation, with minimum of 65% exposure to the top 100 (large-cap) companies. The portfolio would be well diversified across stocks and sectors. The gross equity exposure will always be above 65% of the portfolio, and hence, the fund will enjoy equity taxation. 

The debt portion would be managed conservatively. Investments would be made predominantly into high grade, liquid debt securities, and the portfolio would overall have low to moderate duration. Overall, the main sources of the fund's return and alpha generation would be through the dynamic equity allocation and the underlying equity portfolio. 

What are the factors you consider while arriving at appropriate asset allocation (between equity and debt)? 

Reliance Balanced Advantage Fund adopts a proprietary model based allocation approach to determine the equity allocation and the remaining part is invested in debt instruments. The fund uses a combination of valuation and trend metrics to determine the relative attractiveness of markets, and accordingly choose the net equity exposure. For valuation, one year forward PE, and for trend, a combination of short-term and long-term price momentum would be considered. Low valuation and high momentum would result in maximum equity allocation, whereas high valuation and low momentum would result in minimum equity allocation. 

Does BAF score above pure equity fund over the longer period? 

Reliance BAF attempts to lower equity volatility and offer a superior investment experience for an investor seeking better than fixed income returns over the medium to long term. The fund with its regular rebalancing mechanism is positioned to manage volatility better and can deliver better risk-adjusted returns. 

What will be your suggestion to a retail investor about investment in BAF? 

The product is suitable for investors seeking returns higher than the traditional fixed income products, combined with lower than equity volatility. The fund with its auto-rebalancing mechanism alleviates the need for regular portfolio shifts based on changing market conditions. Hence, we believe the product can be included as a part of core investment portfolio of any investor. We believe the product is well-suited for investors with a moderate risk appetite and medium to long term investment horizon. 

In a live case we can see this working in the case of ICICI Prudential Balanced Advantage Fund. In FY11, when the S&P Sensex TRI grew by 11.48%, the fund grew by 9.87%. In the next financial year (FY12), the BSE Sensex TRI was down by 9.06%, and during the same period, ICICI Prudential Balanced Advantage Fund grew by 5.77%. Same thing happened in FY16, where Sensex TRI was down by 8.9%, but the fund was up by 0.75%. 

The Investment Strategy of BAF 

Not all the funds are made equal and the returns generated by this category of funds in the last one year varies from 3% to 13%. What differentiate these funds is how they allocate their assets between equity and debt. It is not only about choosing the right proportion of assets at the right time, the choice of sub-assets within assets make a difference between a winner and loser. For example, once it has been decided that exposure in equity needs to be raised, the next question is which is the right category to invest, whether large-cap, small-cap or mid-cap. Similar decision needs to be made regarding debt investment. 

Take the case of Aditya Birla SL Balanced Advantage Fund, which takes into account trailing PE ratio of S&P BSE 100 and other ratios like P/B and dividend yield to decide the equity allocation. In case of IDFC Dynamic Equity Fund, equity exposure is decided on the basis of opportunities available at various points of time based on the month-end weighted average PE ratio, with a large-cap bias. In the case of debt, it is conservatively managed with allocation to state government bonds and AAA-rated companies. Reliance Balanced Advantage Fund uses a combination of valuation and trend metrics to determine the relative attractiveness of the markets and accordingly choose the net equity exposure.

At the current juncture, when the market is volatile, BAFs are best suitable to a novice investor. As most of the equity indices are exhibiting volatility with a downward bias, investment in pure equity funds may give them negative returns in the shorter period. This may entail a bad investment experience for a new investor. BAFs can also generate negative returns; however, our study shows that losses of these funds are likely to be lower than losses of pure equity funds. Besides, this fund is also suitable for a conservative investor who does not want to take risk but expects returns better than the traditional saving instruments.