To compare between balanced funds and equity savings funds, as long as you have an adequate investment horizon and risk appetite, balanced funds may be the better choice.
The India growth story remains attractive, but the market is in a fair valuation range. The decision to allocate towards equity is easier when the market is at a relatively cheap valuation level. At this juncture, it is advisable to do a judicious allocation to equity and debt according to the risk appetite and horizon of the investor. The allocation to equity (high volatility-high return) and debt (low volatility-low return) can be done either a) through focused allocation to equity and debt funds, or b) through hybrid funds where the fund manager maintains the ratio between equity and debt. Here’s a look at the parameters that one should compare between the two categories of funds.
Balanced funds, which are a type of hybrid fund, maintain a minimum 65% allocation to equity, which is required for equity taxation rules—if the equity component is less than 65% on a one-year average basis, the fund is treated as a debt fund and taxation would be adverse. Most balanced funds have 65-70% equity allocation.
The other category of hybrid funds is equity savings funds, with allocation to debt, equity and arbitrage, i.e., equity cash-futures hedged exposure. They have an overall 65% allocation to equity to maintain the equity taxation; 30-40% is open or unhedged exposure to equity; and 30-35% is hedged with matching sale position in the stocks in the futures segment.
In the cash-futures hedged component, the returns come from the price differential in the scrip between the cash segment and futures segment of the exchange, and not from stock prices going up.
The strategy behind equity savings funds having 30-40% ‘actual’ exposure to equity, is conceptually a step-up over monthly income plan (MIP) funds, which have 15-20% exposure to equities. But participation in equity upside from the growth in the Indian economy is limited to 30-40% in equity savings funds against 65-70% in balanced funds. So, from this perspective, balanced funds offer better participation, as long as you have an adequate investment horizon.
There is another risk in equity savings funds—which is just a possibility with no timeline to it—on the taxation aspect. The arbitrage component is not a real exposure to equity price movement and if someday the favourable tax treatment to these funds as equity funds is withdrawn, taxation would be akin to debt funds. Nobody knows whether this will happen or not, but the tax treatment is based on a provision in the rules and not on the effective 65% exposure to equities.
In a debt fund, there is a dividend distribution tax (DDT) of 28.84% for individual investors and 34.61% for others. There is no DDT in equity funds. In the growth option in equity funds, there is no long-term capital gains tax either after a holding period of one year. In debt funds, there is short-term capital gains tax at the marginal slab rate up to 3 years of holding. Long-term capital gains tax, after 3 years, is lower but not nil as in equity funds.
The industry exposure to the two categories of funds gives us a perspective on what to prefer. The assets under management (AUM) of balanced funds is around Rs77,000 crore as on end-February 2017. As against this, the AUM of equity savings funds is about Rs5,700 crore. Though the latter type of fund is relatively new as a category and balanced funds have been around in the market for decades, the vast difference in investor preference does tell a story.
Now let us look at performance. It is not an apple-to-apple comparison as the extent of effective equity exposure is different. But we still need to look at performance since we are deciding between the two categories of funds. Over the past one year (till 24 March 2017), returns from a basket of 25 balanced funds was 19.2% on an average. Over the same period, average returns from a basket of 12 equity savings funds (the number of funds in this category is lesser) was 12.6%. To look at a longer period, over 3 years, average returns from 23 balanced funds was 17%. Three-year returns from five equity savings funds (number of funds with 3-year performance) was 10.4% on an average. This reiterates that ‘open’ equity exposure being lower in equity savings funds does not provide the return upside.
To summarize, it is better to do a focused allocation to equity and debt funds, but in that option, the debt funds would be relatively tax inefficient. To compare between balanced funds and equity savings funds, as long as you have an adequate investment horizon and risk appetite, balanced funds are better by virtue of better risk-adjusted returns versus equity funds, higher exposure to equity than equity savings funds and meaningful participation in the equity market, and cleaner tax efficiency than equity savings funds.