Volatility always brings up the demand for stability. Not all investors have a high appetite for risk. There is a large segment of investors who need a relatively stable portfolio. Consider people saving for retirement, risk-averse investors, and goal-based investors who have a fixed investment period, all of whom need stability in their portfolios. Equity funds, while offering a diversified basket of sectors and stocks, are still subject to the volatility that equities are inherently vulnerable to. On the other hand, investments in debt funds rob investors of access to the accelerated growth that equities offer. This is where one should turn to Balanced Advantage Funds.
What is a Balanced Advantage Fund?
Balanced funds, as the name suggests, are hybrid funds, balanced between equity and debt. The equal allocation to debt and equity, though, takes aggressive growth through inflated equity allocation away. Balanced Advantage Funds bridge this gap by keeping the allocation between equity and debt flexible for the fund manager. In a face-off, balance funds vs balanced advantage funds, balanced advantage funds have an edge when it comes to taxation benefits and aggressive growth prospects.
Asset allocation between equity and debt is a process that is algorithm-driven. The overall strategy of these funds is to increase the weightage of equity when valuation is low and fall back on debt securities when equity valuation is high.
The weighting is based on the asset allocation process, which the fund manager executes based on the above considerations of market valuations and market conditions. This dynamic asset allocation between these 2 asset classes helps provide consistent returns to the investors of the fund.
The overall equity exposure must be maintained above 65% for the fund to be taxed under equity taxation. The fund manager, along with the asset allocation strategy based on mathematical models, takes care of this.
The fund makes sure the models and strategies are thoroughly back-tested, and future allocation strategies are based on these test results.
Derivatives are also used by balanced advantage funds to hedge equity bets, making the fund even more risk-averse. Safe arbitrage opportunities are also used to make safe returns.
This allocation strategy used by balanced advantage funds is referred to as counter-cyclical dynamic asset allocation.
Reasons to choose balanced advantage funds
This year is a challenging one for most companies in the world with lower earnings and profitability. Equity investments, therefore, are not very rewarding in the short term at least.
Interest rates are high and are expected to remain high as the central banks around the world try to rein in inflation. Though this makes short-term debt lucrative in terms of stability, it makes exponentially compounded growth impossible.
Balanced advantage funds are a great way to tap into the growth of equities and the stability of bonds in a managed way. Let’s look at the pros and cons of this instrument:
Advantages:
- Equity-driven high growth when markets are on the upswing
- Steady consistent growth during bear markets driven by debt
- Tax efficient returns since these funds are taxed as equity funds
Disadvantages:
- Depends on timely rebalance between equity and debt by the fund manager
- Risk is still present
- At least a 3-5 year horizon is needed for decent returns
Asset Allocation:
- Active equity is the number of unhedged equity assets that the fund manages.
- Fixed income is the component that provides protection from vulnerability in the equity markets, thus stabilizing gains.
- The equity part of the fund is split into active and inactive components. The active equity component is held without any hedges since these were purchased at a “reasonable valuation”. The inactive part of equity holding is hedged using derivatives.
For instance, a balanced advantage fund has shares of “Ropario Industries”, a small-cap stock (a made-up company name for example), in its portfolio, and is expecting the stock to move up as part of the buy low, sell high strategy. To mitigate the sudden volatility that can emerge from this stock price movement, the fund will short the futures of the stock in the derivatives market for hedging.
Now, if the shares of Ropario Industries plummet, the NAV of the fund will take a beating, but the fund will make money off the futures position to recover the NAV. Vice versa will also hold true if the stock price were to move up. This approach reduces volatility for high-beta assets.
Taxation:
Most balanced advantage funds in India maintain asset allocation in such a way that gains are taxed as equity funds. That means the fund holds 65% of its AUM in equities, whereas only 35% or less is held in debt. A short-term capital gains tax of 15% is applicable for investments held for less than 12 months, whereas a long-term capital gains tax is applicable on investments held for more than 12 months. To top this, gains from long-term equity assets are tax-exempt up to 1,00,000/financial year and are 10% for gains over 1 lakh. This certainly outweighs balanced advantage funds or debt funds where short-term capital gains tax is 30% and long-term capital gains are 20%.
A balanced advantage fund is an instrument that is good for all investment conditions. It brings in the best of both worlds—growth from equity and stability from debt. Investing in a balanced advantage fund is most appropriate for these investor segments:
- Risk averse investors
- Investors who are new or without much knowledge of the markets
- Investors who are looking for at least 3 years as their investment period
- People planning their retirement
