A Comprehensive Guide on Balanced Advantage Funds

Are you looking for a mutual fund that gives you the best of both worlds, equity and debt, and adjusts its portfolio as per market conditions? If yes, balanced advantage funds should be on your radar. These funds are a category of hybrid funds. Read on to learn what makes these funds unique and their various other aspects.

What Are Balanced Advantage Funds?

Balanced advantage funds invest in equities and debt that change dynamically as market conditions change. Because of this, they are also called dynamic asset allocation funds. While the fund’s equity component helps in capital appreciation, the debt component helps protect the gains from eroding due to market volatility.

Capital market regulator SEBI allows balanced advantage funds flexibility in their investment approach. These funds can allocate anywhere between 0% and 100% of their portfolio to equity and debt, allowing fund managers to adopt a tactical investment strategy.

Asset Allocation Models Of Balanced Advantage Funds

Balanced advantage funds mainly deploy two types of asset allocation models. These include:

• Acyclical

Balanced advantage funds deploying this model increase equity exposure in falling markets and higher debt exposure in rising markets. This approach, also known as counter-cyclical asset allocation, focuses on buying the dip.

• Cyclical

The cyclical approach is opposite to the acyclical model. Balanced advantage funds deploying this approach raise equity stakes during market highs and increase debt during drops.

How Do Balanced Advantage Funds Work?

Balanced advantage funds employ quantitative dynamic asset allocation algorithms to adjust their asset allocation based on market conditions. Most balanced advantage funds employ counter-cyclical dynamic asset allocation models.

Counter-cyclical dynamic asset allocation methods reduce equity allocation while increasing fixed income and/or hedging exposure when market valuations are high. If stock valuations are low, the model raises equity allocation while reducing fixed income and/or hedging exposure. Counter-cyclical dynamic asset allocation techniques are essentially "buying low and selling high".

Different balanced advantage funds use various valuation criteria for dynamic asset allocation, the most common of which are the P/E and P/B ratios. Some fund managers utilise multi-factor models that include two or more elements, such as P/E, P/B, and dividend yield.

Certain balanced advantage funds may employ pro-cyclical dynamic asset allocation models. Pro-cyclical models seek to capitalise on bull market gains while protecting against bear market losses. Funds that use pro-cyclical models boost their equity exposure in rising markets and decrease it in falling markets.

Some balanced advantage funds may employ a combination of counter-cyclical and procyclical tactics. These schemes' fundamental asset allocation follows the counter-cyclical strategy, while tactically adopting market trend or momentum-based methods (pro-cyclical) to maximise upside potential and limit negative risk.

Benefits Of Investing In Balanced Advantage Funds

Investing in balanced advantage funds brings several benefits. These include:

• Reduced volatility

While mutual funds are subject to market risks, balanced advantage funds tend to reduce volatility by adjusting their asset allocation dynamically. This approach helps balance risks better than pure equity funds.

• Provide diversification

The importance of diversification can’t be emphasised enough. Diversification helps mitigate risks by spreading your money across equity and debt. This strategy helps reduce the impact of the underperformance of any one asset class.

• Automatic rebalancing as per prevailing market conditions

Balanced advantage funds automatically rebalance portfolios according to prevailing market situations. This saves you the effort of tracking and adjusting your investments.

Risks Involved In Balanced Advantage Funds

Balanced advantage funds also carry their own risks. The risks are as follows:

1. Market Risk

In general, Balanced Advantage Funds tend to have some degree of equity exposure in all market situations, although SEBI does not stipulate any strict allocation limits. Due to this fact, the share value of the portfolio is vulnerable to market fluctuations. In case the stock markets fall drastically, then the equity investments in the fund can also decrease. Although this type of strategy may minimise the exposure to equity in a declining market, the strategy is not able to avert market risk altogether.

2. Interest Rate Risk

Interest rate risk arises from the debt component of balanced advantage funds. Interest rates tend to have an inverse relationship with the direction of bond prices. As interest rates increase, the price of the fixed-income securities decreases, and vice versa, the price of the bond tends to go higher as the interest rates go down. This risk is dependent on the fixed-income portfolio of the fund to a great extent. Bonds with longer maturity dates will tend to be more susceptible to changes in the interest rate and can also have substantial changes in price.

3. Credit Risk (Issuer Default Risk)

Balanced Advantage Funds can also invest in corporate bonds or other debt instruments, which have credit risk. Credit risk can be explained as the likelihood that the issuer of a bond will default on the interest payments or repay the debt. The value of the affected securities may decrease in the event that the financial condition of the issuer deteriorates or due to a default, and this can adversely affect the overall returns of the fund.

4. Derivatives and Strategy Risk

Many balanced advantage funds use derivative strategies such as arbitrage or covered calls to manage market risk and generate additional income. These strategies can sometimes help offset the risk from unhedged equity exposure. However, the effectiveness of these strategies depends on prevailing market conditions.

Taxation Of Balanced Advantage Funds

Balanced advantage funds are taxed based on their equity orientation. If the equity orientation is more than 65%, the funds will be taxed as equity funds. Therefore, long-term capital gains (LTCG) above ₹1.25 lakhs in a financial year without indexation will be taxed at 12.5%. On the other hand, short-term capital gains are taxed at 20%.

On the other hand, if the fund has a higher debt component, it is taxed like debt funds, where the gains are added to income and taxed according to your tax slab.

Who Should Invest In Balanced Advantage Funds?

Balanced advantage funds are a prudent option for several types of investors. These include:

• New investors

As a new investor, you can start your mutual fund investment journey with balanced advantage funds. They expose you to equities and debt without requiring you to manage the investment.

• Investors with moderate risk tolerance

Balanced advantage funds can be a good investment choice for investors with a moderate risk tolerance. This category of investors look to take some level of risk but doesn’t prefer extreme volatility. They aim to balance potential growth with capital protection.

Identifying The Top Balanced Advantage Funds

You need to remember certain things while identifying the best balanced advantage fund. These include:

• Fund’s long-term returns

Evaluate the fund’s long-term returns across 5 or 8 years. See how consistent it has been and, more importantly, how well it has contained losses during market downturns.

• Fund manager’s track record

Analyse the fund manager’s track record and the funds managed by him / her. See the performance of the funds managed.

• Ensure the fund aligns with your goals and risk appetite

Last but not least, make sure the fund aligns with your goals and risk tolerance. This ensures money is available to you at the right time when needed.

Wrapping It Up

Balance advantage funds can help balance risk and reward by employing dynamic asset allocation. That said, it’s crucial to ensure that the fund fits into your overall financial objectives. Start small and see how the fund performs before committing big.