For moderate risk takers balanced funds are a better option than the more volatile equity diversified funds
Over the last five years, equity markets were surging northward and equity funds, especially new fund offers (NFOs), were the flavour of the season. During the bull run, many equity investors? had loaded their portfolios heavily with equities in order to earn high returns. Since January, the Sensex has plummeted nearly 52 per cent, causing serious damage to the portfolios of such investors.
Now, investors are waking up to the virtue of asset allocation. They might well consider investing in balanced funds, a type of fund that includes both equity and debt in its portfolio. These funds invest in stocks, bonds, and money market instruments. They are classified into two broad categories:
Equity-oriented balanced funds. These funds invest at least 65 per cent in equities and the balance in debt. They are suitable for investors who want to benefit from the equity market but want the cushion provided by debt as well.
Debt-oriented balanced funds
. They invest a larger proportion in debt instruments such as bonds and have limited exposure to equities. They are more suited for risk-averse investors.

Features
Dual purpose. Balanced funds combine the low-risk benefit of fixed income with the high-return potential of equity. They invest in stocks, bonds and other debt instruments to provide both income and capital appreciation while avoiding excessive risk. The purpose of such funds is to provide investors with a single mutual fund scheme that combines both growth and income objectives.
Rebalancing. Another distinct advantage of these funds is that they continuously rebalance their portfolios to ensure that the asset allocation is not disturbed. These schemes maintain an equity-debt ratio as per their investment objective. If the fund manager diligently rebalances the portfolio, the investor is assured that the profits earned from the stock markets are invested in low-risk instruments. This allows the investor to maintain the appropriate asset mix, without him undertaking the hassle of rebalancing the portfolio on his own.
Tax benefit. Balanced fund having an equity exposure of nearly 65 per cent enjoy a tax treatment akin to that of equity funds. The dividend distribution tax and the long-term capital gains tax are exempted. They are subject to short-term capital gains tax of 10 per cent, if redeemed within a year. So the equity-oriented balanced funds avoid the dividend distribution tax and are hence cost efficient.

Performance
Most debt-oriented and equity-oriented balanced funds have outperformed their category average and the benchmark index Crisil MIP Blended and Crisil Balanced index respectively over the one-, three- and five-year horizons (see table showing their performance).
According to Prasunjit Mukherjee, a Kolkata-based mutual fund analyst, ?The reason for the good performance of these funds lies in the fact that most investors are retail investors. Those who invest in balanced funds tend to be committed investors. There aren?t too many corporate investors in these types of funds, so the volatility of assets under management (AUM) is less.?
As is to be expected, balanced funds provide better cushioning against downside risk, but tend to underperform diversified equity funds over the five-year horizon. Their exposure to debt means their returns are lower.

Not flexible enough
While one of the key selling points of balanced funds is their ability to change asset allocation according to market conditions, here they are hemmed in by regulation. Says Apoorva Shah, senior fund manager, DSP BlackRock Investment Managers, who manages DSP?s balanced fund: ?Currently we have an asset allocation of 65 per cent in equities (the minimum level), down from a maximum level of 75 per cent. We have gone conservative in our allocation. One cannot move below 65 per cent due to tax benefits (the fund would then not be treated as an equity fund), neither can we go above the maximum limit of 75 per cent.?
Adds Mukherjee: ?In the current downturn, balanced fund might go for holding more cash and slightly less equity. The debt allocation would remain more or less the same as the debt market is shallow.?

Bottomline
Balanced funds provide good returns at a relatively lower level of volatility and are suitable for the moderate risk taker. A recent analysis done by us showed that with balanced funds (equity-oriented), you stand a very high (80 per cent) chance of achieving index-beating returns over a five-year horizon, far more than in the case of diversified equity fund (with which your chances of beating the index are only 63 per cent over the same time horizon).
?The cost of managing these funds is low as there is not much volatility in AUM. These funds will do well over a twelve-month horizon. Investors seeking dividend option should go for such funds,? says Mukherjee.