The Hindu Business Line : Balanced funds forced towards stocks

For balanced mutual funds, this is one Budget where the devil is truly in the detail. By tweaking the definition of equity-oriented funds to include only those funds that have invested at least 65 per cent of their assets in equities, the Budget proposals put balanced funds in a quandary.

Until now, funds with an equity exposure of 50 per cent or more were defined as "equity-oriented funds". Investors in these funds are exempted from paying long-term capital gains tax; and short-term gains are taxed at a concessional 10 per cent. Equity funds are also exempt from paying dividend distribution tax, at 12.5 per cent for individuals, when they pay out dividends.

Balanced funds that would like their investors to enjoy lower rates of tax will now be forced to retain their equity exposure at 65 per cent, or a higher proportion, of their assets. Funds that prefer a conservative equity exposure will have no choice but to forego the tax benefits. Rather than lose the tax benefits, most balanced fund managers may opt for a permanent higher allocation to equities. The proposals, if passed into law, take effect on June 1.

More equity exposure

Given the substantial tax benefits associated with being classified as an `equity-oriented fund', most fund-houses are likely to tweak their balanced funds to fit in with the new objectives.

The immediate impact on the asset allocation pattern of balanced funds may not be too significant. With corporate earnings growing at a healthy clip and the stock market on a dream run, most fund-houses have taken a bullish view on equities and maintain a high equity allocation in their respective balanced funds.

Tilted towards equities

Of the various long-running balanced funds, Franklin Templeton India Balanced Fund, Magnum Balanced Fund and Kotak Balance already had equity exposures of 65 per cent or more by end-January 2006. Others such as Sundaram Balanced and PruICICI Balanced, were at a 64 per cent equity exposure and need only to peg it up a whisker to make it over the threshold. Only HDFC Prudence had an equity allocation substantially lower than the threshold, at 59.9 per cent, by end-January.

Of course, the equity allocation for this purpose is reckoned on the average monthly balances through the year. Therefore, a fund need not necessarily retain a 65 per cent equity exposure at all times to be eligible for the tax benefits. There could be temporary spikes or a shortfall in the equity allocation over a month or two that could be made up in the rest of the year.

Since these proposals take effect only in June, funds have a fairly long, three-month window to think through and rejig their asset allocation pattern.

Less flexibility

But it is the loss of flexibility that this rule entails that is a greater worry for investors in balanced funds. With the proportion of equity investments in a balanced fund straitjacketed at 65 per cent, managers of such funds will have less flexibility to move to debt investments if the equity market appears overheated.

Individual investors, on their own, are seldom savvy enough to book profits on their equity portfolio at the right time, given the difficulty of taking a view about stock valuations or the direction of interest rates. Managers of balanced funds are better placed to make this call.

Most balanced funds at present have considerable leeway in their asset allocation. Their objectives usually allow equity investments to swing between 40 per cent and 60 per cent of their assets. In practice, though, equity investments account for 60-65 per cent of the assets.

This flexibility has stood some funds in good stead. Successful balanced funds such as HDFC Prudence have turned in an impressive performance by making this kind of "tactical" asset allocation call.

If the equity exposure in this fund is "fixed" at 65 per cent, the fund may have to load up on stocks, irrespective of whether the fund manager is really comfortable with such an allocation. Investors could lose out on the value addition that comes from fluid asset allocation.

Balanced funds still attractive

Do these proposals make investing in balanced funds an unattractive proposition? Could an investor substitute a balanced fund by investing 65 per cent of his money in equity funds and 35 per cent in debt funds? No, because balanced funds will continue to offer three distinct advantages over this strategy. One, balanced funds periodically re-balance assets between equity and debt — difficult for an individual investor to manage on his own.

Second, the tax advantages over direct investing. When a fund manager books profits on stocks or bonds to re-balance his portfolio, the fund pays no capital gains tax on these transactions. As an investor, you will have to pay short-term capital gains tax, if you rejig your portfolio at short intervals.

Third, balanced fund managers will still be able to add some value on asset allocation. They could choose to have a much higher equity exposure than 65 per cent and juggle between the debt and cash components.

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