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The Mutual Fund Show: What’s Hurting Balanced Funds? 

Balanced funds were considered the gateway to equities for risk-averse investors. That may have changed.

Outflow of Rs 1,077 crore from balanced funds in February were the highest in a decade, according to data from Association of Mutual Funds in India. That was due to mis-selling and regulatory changes, according to Aashish Somaiyaa, managing director and chief executive officer at Motilal Oswal Asset Management Company. And, he said, such schemes gave lower-than-expected returns.

Probably, these funds were sold promising that they will give lower returns than equity but also reduce volatility, Somaiyaa said on BloombergQuint’s weekly series, The Mutual Fund Show. “They were expected to deliver returns better than fixed income. In between, dividends were made taxable,” he said, referring to the decision announced in the budget last year. That hurt returns as, according to Somaiyaa, fund houses found it difficult to make the payouts.

Watch the full episode here:

Here are the edited excerpts of the interview:

There were new valuation norms for money market and debt market securities. It is a big change. Does it impact the life of average retail investor? Or would you reckon that those investors are served by other categories and not necessarily by liquid funds?

Aashish Sommaiyaa: Lot of people, for their overnight or emergency requirements, find liquid funds is the safest in industry. Because by definition it will not carry any credit or duration risk. From a retail investor’s perspective, they should keep their surplus in liquid funds of whatever is required in 24-hour notice. I don’t think it will impact them dramatically. On margin, it does impact what maturity of paper the fund would like to hold so that their NAVs are not very volatile. Anybody who is investing for 7-10 days, I don’t think it will change for them very dramatically.

Harsh, would you get queries from your clients and what is the advice for them?

Harshvardhan Roongta: Not really. If you look at changes in liquid fund category, then only the high-profile investors or institutional investors would be tracking it minutely. For retail investors, who are investing Rs 50 lakh to Rs 1 crore for temporary parking money, they aren’t bothered about it.

What are the alternatives? If he has to keep this money in bank account, it could earn 3.5-4 percent. Against which any product is offering 5-6 percent in that case, it is good enough. When you are parking money from a liquidity point of view, returns are not your objective. The idea is to earn something but have the accessibility to that money. I don’t think it is that kind of concern as much as it is trying to be made out of.

Flows into balanced funds turn negative in January for first time since May 2014. Two years ago, we were talking about how balanced funds was the place to be in. What has changed in less than 24 months?

Aashish Sommaiyaa: I don’t think the relevance or the product construct has changed dramatically. In balanced funds, there is one category which is dynamic and balanced advantage, wherein the equity exposure is calibrated in consonance with some other valuation indicators. Then there are balanced funds which are supposed to operate in a tight range of 65-70 percent equity. One is variable allocation and other is fixed allocation. They are supposed to churn out return and risk volatility in certain measure. I don’t think anything has changed from the perspective of construct. I don’t think anything from relevance perspective has taken a hit.

If you see one-year returns of some of these categories of products, what has happened is that when there was huge flow coming the in the industry, it was believed that the dynamic or balanced category is a great category for people who are entering the industry. After demonetisation, rates collapsed which coincided with huge inflows. I won’t be surprised that a lot of people who were erstwhile fixed deposit investors have started investing in this. Probably these funds where positioned where they would give lower return to equity but it will cut volatility by a very large margin. So, they were expected to deliver returns in certain space which is much better than fixed income. The whole deal was used by saying these funds will give dividends every month. If you are given a feeling that you will do better than fixed income and yet your cash flows will be taken care of by way of payouts, then you enter with certain expectations.

Fast forward to where we are right now. Before this humongous rally that started in March, a lot of balanced funds had zero return in last one year. In July 2017 or August 2017, they might even be showing negative return in that time frame of 17-18 months. You come with a certain set of expectations and then reality hits. In between dividends where made taxable. In between, I also heard of some funds not being able to keep up with monthly payouts.

Product category and relevance hasn’t changed but you have got a bunch of people with certain expectations and those expectations are not being met at this point in time.

A common topic for conversation used to come about 6-9 months ago was the mis-selling of balanced funds as dividend paying funds for perpetuity. Does this come up too often?

Aashish Sommaiyaa: I don’t think the word comes up in that sense that it is mis-selling. But it was there in the numbers, the delivery, in terms of volatility, in terms of beating fixed income, and for monthly payouts. The entire delivery and track record have demonstrated it. You see there is a lack of correlation between large cap and mid cap. In balanced fund, it is possible that you have taken a knock-on equity as well as fixed income side. Last year, the 10-year bond and fixed income was all over the place. It is more situational. It is yet another learning that past performance is not an indicator of future. Product is bought based on some communication and certain expectations which are not met. At some level if somebody hasn’t explained that this is what the past shows, but you need to prepare for these eventualities. In our country dividends are taxed at all levels. Even mutual fund dividends have been taxed which is unexpected. So some things are unexpected, and some things could have been communicated much better, which is the challenge.

Do you clients come up and say that they are disenchanted with balanced funds?

Harshvardhan Roongta: If you look at the entire profile of investors who came into investing in balanced funds with monthly income as an expectation was an unaware investor. They have been fixed income investors who have been dissatisfied with reduction in interest rates and all those stories. A portion going in equities and being a regular income person have got them here. I have come across people who have come and back-tested something suggested to them saying that is this true. This has been a query that will we get monthly income out of this. Rate of return is also indicated that you will get 0.75-1 percent a month. All this has been mis-selling.

Putting that into perspective and seeing what has happened today—2018 was completely flat in terms of return for this category. People have been disgruntled with it. It is natural for them to move out.

There is a product which has been designed and as a manufacturer, it is responsibility to have a product category for all types of investors. The problem arises when something else has been shown and given to investors whom it is not suitable for. You need all kinds of products. You need balanced funds. As per SEBI categorisation, you need conservative hybrid, aggressive hybrid. If a product is designed by manufacturer does not mean it has been designed to garner some assets and under that particular category. As an option, you are supposed to have it. The responsibility lies in the investor and the intermediary to place right product with the right investor. Had that happened properly, then we will not be in this kind of situation.

What kind of investors should go and invest in balanced funds? Is there any category that might be better serving than balanced funds?

Aashish Sommaiyaa: I don’t think people will lose out money. The journey they thought they would have versus the journey they have had in last 18-24 months, there is a complete dissonance on what was expected. We have belief and confidence that they will not lose out. They might have come into a product expecting something or for wrong reasons, but I don’t think they will lose money. It is just that the journey is not as smooth as it would have been.

We don’t have to get carried away with short-term occurrences. In the last few days, there has been a recouping of values because of what you have seen in the market. I am happy for the people who were monitoring their investments closely.

Product is still relevant. One of the categories in hybrid and balanced categories is dynamic or balanced advantage funds which calibrate the move. When balanced fund was at -5 or -10, lot of these funds were at zero return or -1 or +1. So, they braced for the impact. The category is relevant. It offers a risk return which lies somewhere between fixed income and equity. So,there are stepping stones.

What kind of an investor is this relevant for? One, who is not doing his asset allocation with his adviser or himself. But for better experience and simplicity, they want to buy one product which is multi asset and who are looking for equity exposure with lower volatility. So, there is a market and it is a relevant product. What to expect out of it should be clearly understood and well communicated.

With the way the markets are shaping up right now what is the advice you will give to investors?

Aashish Sommaiyaa: We have a dynamic category fund. In October, we have created an equity hybrid fund. We have funds in those categories, but we don’t pay monthly dividends. We encourage people to understand the concept of systematic withdrawals. If you expect the underlying asset or fund on hybrid basis to grow at 10 percent and you set a withdrawal rate of 0.7 per month, so you are withdrawing at the rate of 8.5 percent. Let’s say you stay invested for five years, in five years on an average the fund grows at 10 percent CAGR and you are consistently withdrawing a fixed rate of 8.5 percent. You will not break your capital but preserve it and will meet your cash flow requirement. You will get better return than fixed income.

The dividend thing is actually misleading. When I say dividend, you think you’re supposed to get it, it is your entitlement, which it is not. Dividends are not in anybody’s control. It is the fund accountant or fund manager decides and then there is taxation. How do people plan for annuities? The underlying asset is going at a certain rate and you are paying out withdrawals at certain rate. It is a known concept. The only learning is not to mix your return expectation with your cash flow. Lot of people are very confused. You have to segregate cash flow from return. The underlying fund may give a return of 10-11 percent, but you take the cash flow of what you need the cash flow to be. Make sure that your withdrawal of cash flow is lower than the actual return that the fund has the potential to deliver. We have these products and we are trying to communicate it differently.

For what kind of investors is this category relevant?

Harshvardhan Roongta: We have always been advocating that you would want to have an asset allocation plan in place. Irrespective of age and risk that you can take, we advise investors to have debt and equity both in their portfolio. If we recommend 70 percent equity and 30 percent debt, one way of going about it is pick 70 percent equity directly in equity fund and put 30 percent in a debt fund separately. Which means you have to constantly re-balance this on your own. Suppose you are looking at equity market doing exceedingly well and debt being what it is doing in normal way, so the allocation to equity will go up in a year. If you have to come back to 70-30, you will have to sell-off equity and allocate to debt. This is a manual process and you have to do it yourself. Irrespective of how disciplined a person is, we have seen investors over a period of time tend to get overridden by emotions. While we started with 70:30 ratio, if equity markets started doing well, they will expect it to do much better later on, forget the asset allocation that was originally designed for them. A balanced fund in that space does this automatically for you. If a fund manager has to allocate 70:30, he will keep doing this at every level so that 70:30 ratio is maintained. The person who wants to automatically do this and not get involved himself, then balanced fund is very good category to be in. Just get one product and you are sorted for asset allocation bit.

The second category is for one who are trying to explore equity. They try to venture into equity investing but they are not confident of putting entire money on one shot. Then you have conservative hybrid products. We are talking about efficiency and taxation part. But let’s understand investor profile.

If a person has been fixed income investor all the while and you are telling him that this will not help you beat inflation. By itself, debt will not create wealth. There has to be some equity allocation which could be 10 percent or could be 25 percent. Again, the reverse calculation is do you do it yourself separately or you have a product designed and kept for you which is a conservative hybrid product, which will have equity allocation of say 25 percent. In that case, you will want to venture into it and test your capability to absorb the volatility and to understand what is happening. Then you increase your equity allocation or move to an aggressive hybrid or move to 100 percent equity late.

As a manufacturer, it is your responsibility to make sure that you have a product which is catering to different kind of investors. If an investor wants 10 percent equity allocation and if you don’t have it in your basket, then you are not doing justice being a manufacturer. At the same time,if a person wants 70 percent equity and 30 percent debt, though he has a choice to do it separately himself, he may have to take just one product and sort it out himself.

Would you reckon that for somebody who has a longer term horizon to just go to pure play equity funds?

Aashish Sommaiyaa: People will realise the need for this. We have certain sets of beliefs and expectations. I am positively inclined. But the reality is that when people are signing a form and giving a cheque then they are all long-term investors. But when the journey plays out, then the long term is out of window and then it is emotions and thoughts driving the process. When there are people who cannot take downside beyond a point even at cost of capping their upside then they need risk return combinations. In a five-year journey, equity will do very well and immediate prospects might look bright. But we will have a period which will not be that great and we will see capital correction. It is a question of what people can tolerate. That is why we need all these combinations.