Balanced funds have been around in India for more than 20 years. Balanced funds enable the investors to get exposure to equities and consequently earn excellent long term returns with significantly lower levels of risks compared to equity funds.
What are Balanced Funds?
Balanced Funds are hybrid equity oriented mutual fund schemes. These funds usually invest 65 – 75% of their portfolio in equity securities and the remaining portion in debt or money market securities. The hybrid portfolio moderates the fund volatility to a certain degree while enabling potential wealth creation in the long term. Since at least 65% of the portfolio is invested in equity or equity related securities, balanced funds are subject to equity taxation. Long term capital gains, for investment period of more than 1 year, is tax exempt. Short term capital gains, for investment periods of less than 1 year, is taxed at 15%. Dividends from balanced fund schemes are also tax free.
While equities give the highest returns in long term, the fact remains that equities are highly volatile assets in the short term, which means that you can make losses in the short term. Volatility is, psychologically, very stressful for retail investors. We have seen that, many retail investors start their investments in equity mutual funds lured by high returns, usually at the peak of bull markets. Bear markets inevitably follow bull markets, and when these investors make big losses they redeem their investments and turn away from mutual funds, harming their own financial goals in the long term
Risk adjusted return is the return you get for a given amount of risk. Let us illustrate with the help of a simplistic example. Suppose a mutual fund scheme “A” can give you 20% returns. But there is a 30% probability of making losses. Another mutual fund scheme “B” can give you 15% returns with a 10% probability of making losses. Which fund will you go for? If you are willing to accept a 30% probability of making losses, then you will go for fund “A”. But if you are unclear, the amount of loss you are willing to accept, then by selecting fund “B”, even though you get 5% less returns than fund “A”, you cut down the probability of making a loss by 20%. This, in very simplistic terms, is the essence of risk adjusted returns. The financial measure of risk adjusted returns is a bit more complicated and is known as Sharpe Ratio. Sharpe ratio is defined as the ratio of excess return (i.e. difference of return of the fund and risk free return from Government securities) and annualized standard deviation of returns (a measure of volatility risk of a fund). Higher the Sharpe ratio better is the risk adjusted performance of the fund
We always strive to be as data oriented and analytical as possible in our observations. Many mutual fund investment experts say that, balanced funds give better risk adjusted returns than equity funds. Is there an analytical foundation to this statement? Yes there is and this is what we will discuss in the rest of this post. We will look at the risks and returns of different equity fund categories and balanced funds with actual historical data to examine the risk adjusted returns of these different categories of mutual funds. Sharpe ratio as a concept is easy enough to understand, but the numerical values of Sharpe ratio is not so easy to grasp from a risk return perspective. We will look at actual returns and the risks.
The chart below shows the comparison of average annual returns of large cap and small/midcap funds categories over the last 10 years, from 2006 to 2015
We can see that, with 2006 and 2015 being exceptional years, small and midcap funds outperformed large cap funds in bull markets and underperformed in bear market. This is consistent with the risk return characteristics of these two categories of equity funds. Let us now see the difference in average annual returns between the small/midcap funds and large cap over the last 10 years
The average difference in annual returns of small/midcap funds and large cap funds was 7%. The outperformance of small and midcap funds versus large cap funds was only to be expected, because the small and midcap funds are more risky compared to large cap funds. But remember, we are concerned with risk adjusted returns. So how much risk did small and midcap funds take versus large cap funds? Volatility or standard deviation of returns is the most common measure of risk. The volatility (or annualized standard deviation of returns) of small and midcap funds over the last 10 years was 29%, whereas that of large cap funds was 24%. Therefore the difference in volatility, or in other words risk, between these two fund categories is about 5%. You will recall that the difference in returns between small/midcap and large cap funds is about 7%. You can see that the difference in risk (volatility) and returns are similar, with small/midcap funds giving slightly better risk adjusted returns compared to large cap funds.
Let us now see the comparison of average annual returns of large cap and diversified equity funds categories over the last 10 years, from 2006 to 2015. You may recall that diversified equity funds invest in both large cap and small/midcap stocks. Therefore, their risk return profile is to be somewhere between large cap and small/midcap funds.
We can see that, with 2006 being an exceptional year, diversified equity funds outperformed large cap funds in bull markets and underperformed in bear markets. This is consistent with the risk return characteristics of these two categories of equity funds. Let us now see the difference in average annual returns between the diversified equity funds and large cap over the last 10 years
The average difference in annual returns of diversified equity and large cap funds was 2%.You can see that the differences between diversified equity funds and large cap annual returns are lower than the differences between small/midcap and large cap equity funds, as expected. How much risk did diversified equity funds take versus large cap funds? The volatility of diversified equity funds over the last 10 years was 25%, whereas that of large cap funds was 24%. Therefore the difference in risk, between these two fund categories is about 1%. You can see that the difference in risk (volatility) and returns are almost the same. Therefore, the risk adjusted returns of large cap and diversified equity funds are almost the same.
Let us now see if balanced funds gave better risk adjusted returns compared to large cap, diversified equity and small/midcap funds. The chart below shows the comparison of average annual returns of large cap and balanced fund categories over the last 10 years, from 2006 to 2015.
We can see that, as expected, balanced funds underperformed large cap funds in bull markets and outperformed in bear markets. Let us now see the difference in average returns between the balanced and large cap funds over the last 10 years
The average difference in annual returns of balanced funds and large cap was -4%. Therefore large cap funds outperformed balanced funds by 4%. But how much risk did large cap funds take versus balanced funds? The volatility of large cap funds over the last 10 years was 24%, whereas that of balanced funds was only 11%. Therefore, while large cap funds took 13% more risk than balanced funds, the difference in return was only 4%. It is evident that balanced funds gave better risk adjusted returns than large cap funds. Compare the differences of return and risk of balanced funds versus large cap funds, with the differences of return and risk of diversified equity versus large cap funds and small/midcap versus large cap funds respectively. It will be clear that, balanced funds outperformed large cap, diversified equity and small/midcap funds. Please note we have compared the risk and return of these different fund categories using a fairly simple analysis, so that the average (not so finance savvy) readers can grasp the concept of risk adjusted returns. Even if we use a more sophisticated an accurate measure of risk adjusted returns like the Sharpe Ratio, the results are fairly consistent, with our findings above.
Why balanced funds were able to give higher risk adjusted returns? Because balanced funds keep rebalancing their asset allocation to maintain their asset allocation (equity and debt) ratios within a certain range. They shift from equity to debt when equity valuations are high and from debt to equity when equity valuations are low. In this blog post, we have discussed why balanced funds are one of the best investment options for new investors. They are equally good investment options for even experienced investors who can use these funds for managing their asset allocation between equity and debt. The equity taxation of balanced funds also makes it attractive for investors. Investors should consult with financial advisors, if balanced funds are suitable for their investment portfolio.