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Sunday, February 22, 2009

Should you invest in Balanced Funds?

As the bulls and bears continue their fight for dominance in the stock market, risk averse investors are probably having a tough time deciding what to do, and when to do it.

In this post on December 8, 2008 I had advocated periodic investments in the Nifty BeES ETF (Exchange Traded Fund) from Benchmark Mutual Fund. ETFs are bought and sold like equity shares in the stock market any time during the trading day at the prevailing price. No entry or exit loads apply, but STT (Securities Transactions Tax) is payable.

What I had not mentioned was that since ETF transactions are made through a broker in a stock market, one needs to have a demat account. Many mutual fund investors may not have - or may not want to have - a demat account.

For such investors, ETF is not an alternative. Should one invest in index funds alone? Yes, if you are a passive investor who does not like to keep track of market goings-on and do not mind waiting for a long time to get returns on your investments.

But remember that an index fund has as much risk as owning the top index stocks. If the index rises 100%, so will an index fund. But when the index falls 60%, the index fund will fall a similar amount.

If you wish to reduce risk further, periodic investments in a balanced fund could be a viable option. Why? Balanced funds are like diversified equity funds that invest a portion of their corpus in fixed income instruments. Such instruments may be fixed deposits, Govt. of India securities, bonds, Non-convertible debentures (NCD), commercial paper.

The fixed income portion can be up to 35% of the total holdings to qualify for availing short and long term capital gains tax benefits similar to a pure equity fund.

The equity portion is balanced by the fixed income portion. This reduces risk because the down side is limited by the regular earnings from the fixed income instruments in the portfolio of the fund. While the average diversified equity fund had fallen 55% in the recent bear mauling, the average balanced fund fell around 41%.

However, in a bull market, the NAV growth of a pure equity fund is higher than a balanced fund because the upside gets capped by the lower return from the fixed income portion.

So which balanced funds should you own? The two best funds in terms of recent as well as long term performance are DSPBR (earlier DSPML) Balanced fund and Magnum Balanced fund. The former has around 20% of its portfolio in fixed income instruments, while the latter has nearly 30%.

I prefer the dividend option over the growth option when investing in mutual funds. The periodic dividends are akin to partial profit booking, and provides liquidity.

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