Over the last 18 months, an unusual trend has been observed. There has been a swift and steady outflow of capital from fixed deposits into balanced funds. Fixed deposit investors have always looked towards avenues that offer fixed returns and guaranty protection of capital. Balanced funds promise neither. So, how did they become an attractive alternative to the traditional fixed deposit?


A Miracle Solution

The nature of the debt marked changed in the past few years for retail investors. Tax structures favoured equity over debt. One on hand, investors had to hold debt investments for three years to claim indexation benefits on their long-term holdings. On the other hand, dividends from debt mutual funds were issued post dividend distribution tax of 28%. Further, returns across the debt spectrum fell rapidly as interest rates fell. This ruled out debt funds from the offering.

On the contrary, equity markets enjoy zero dividend distribution tax. Additionally, long-term capital gains (LTCG) are currently exempt from tax. While debt markets hit a rough patch, equity markets have been following a one-way trajectory…upwards.
Balanced funds have been pitched as a suitable alternative to fixed deposits because they also have a debt component. Banks aggressively sold these funds to clients. This is yet another instance where banks have prioritized their revenue interests over their clients’.

Balanced funds were a miracle solution – they were offering seemingly higher returns than FDs while supposedly being safe. In addition, they are more tax efficient and were even offering to pay regular monthly dividends. Unlike interest income, these dividends are tax-free.

Latent Issues

Balanced funds are a type of equity mutual funds that invest a minimumof 65%of the portfolio in equity instruments. This makes them an equity product. Most balanced funds currently follow an aggressive investment strategy on their equity portfolio to cope with the inflows and to deliver the promised returns. This makes them inherently ill-suited for conservative investors.

More importantly, regular dividend payouts are not sustainable. In mutual funds, dividends are paid from booked profits in a scheme. Essentially, the fund houses sell securities to book profits and this is handed back to investors in the form of dividends. It’s important to note that if the markets correct, the dividend will be paid from invested capital.

Balanced funds have been touted as the ideal asset allocation fund. However, since a majority of the investment is in equity instruments, it can’t work as a “one-size fits all” solution. The more prudent choice would be to work towards asset allocation across debt and equity. For regular sustainable cash flows from mutual fund investments, a prudent Systematic Withdrawal Plan would make more sense.

The Way Forward

A market correction could see the flight of capital from balanced funds if there is NAV erosion. Traditional investors who were avoiding the volatility of debt markets will not be able to tide through the volatility of equity markets. A sudden reversal of flows will primarily hurt investors who pull their money out, but it will also affect those who choose to stay the course.

At ithought, we have been working towards creating fixed-income solutions for our clients that are customized to their cash flow and return expectations. If you would like to explore our offerings, please get in touch with us.

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