One of the major advantages of investing in mutual funds is that there is a wide choice or array of options on offer. Depending on your risk appetite you have liquid funds at the shortest end of risk to sectoral funds and thematic funds at the longest end of risk. You can choose the funds according to your own risk appetite and your risk capacity. Let us look at a comparison of two such funds; balanced funds and focused funds.
What are balanced funds?
Balanced funds, as the name suggests, refer to an eclectic mix of equity and debt in the same portfolio. As per the SEBI revised definition, balanced funds come in three broad categories as under:
- Equity balanced funds that have an exposure of greater than 65% to equities. This exposure is calculated on a regular and periodic basis. The equity balanced funds offer you the higher returns of an equity exposure with the stability and regular returns from a small portion of debt in the portfolio. For the purpose of taxation, these funds are treated as equity funds.
- MIPs or debt balanced funds. In contrast to the equity balanced funds, the MIPs or debt balanced funds have a higher exposure to debt as compared to equities. The debt exposure normally ranges from 70% to 85% with the balance invested in equities. For the purpose of taxation these funds are treated as debt funds (non-equity) funds. They are more for investors who are looking at stability with a small equity component to give the alpha in markets.
- Arbitrage funds are an equity fund by definition but the payoffs are like a debt fund. In an arbitrage fund, the fund manager will create an equity portfolio and create an offsetting position in equivalent number of future. For example, Buying 1000 shares of Reliance and selling 1 lot of 100 shares of Reliance Futures is an arbitrage trade. Normally, the cash position is held on to but the futures are rolled over each month. The spread between cash and futures is captured and the returns are in the region of 7-8% annualized. The big advantage is the tax treatment as such funds are classified as equity funds considering the equity exposure of more than 65%
Who should invest in balanced funds?
Balanced funds are ideally for those who prefer the mix of equity and debt in their portfolio. Depending on your fund return expectations and your risk appetite you can choose between a range of balanced funds from MIPs to equity balanced funds. Balanced funds are ideally when you plan goals in the range of 3-5 years. Beyond that, normally diversified equity funds work best. Balanced funds give you an automatic combination of equity and debt and that saves you the troubles of combining equity and debt on your own. Balanced funds have done well when the equity and the bond scenario are fairly uncertain.
What are focused funds?
Focused funds are a type of equity funds where the focus is entirely on one sector or one theme. For example, an FMCG Fund or Banking Fund is examples of sector funds. Similarly, funds like Commodity Funds, Mid Cap Funds and Consumption Funds are examples of thematic funds. Both sector funds and thematic funds are jointly referred to as Focused Funds. You need to remember that these focused funds are riskier compared to diversified equity funds. Since they are focused they are not diversified which is one of the basic purposes of investing in mutual funds. Focused funds can do really well if you catch these funds at the bottom of the cycle but can give negative results if you buy at the top of the cycle. E.g. buying infrastructure funds in 2008 would have been bad for your portfolio.
When to use focused funds?
Ideally, focused funds cannot be looked as a replacement for diversified funds. Your core equity fund portfolio should still be in diversified funds only. But you can look to create alpha by adding some portion of these focused funds into your portfolio. This is an aggressive trading decision and you need to talk to your advisor and be clear that you are buying at the bottom of the business cycle.
In a nutshell, balanced funds and focused funds have a different set of risk needs and return expectations associated with them. They are more like apples and oranges when it comes to a comparison. Invested properly and within limits, both have the potential to add value to your mutual fund portfolio.