A reader asks, “I understood the importance of asset allocation/annual rebalancing exercise from your old article. I see the below text by one of the leading BAFs (see link below) – When investors manually move their money between equity and debt, they could be subjected to taxes on the capital gains made in the short term. However, when fund managers move between the two asset classes as a part of their routine rebalancing, they need not pay these taxes because of the way the fund is structured. Furthermore, even after the rebalancing, the tax treatment of the fund continues to remain equity-oriented, which is ultimately beneficial for investors, as equity funds pay a lower tax rate as compared to debt funds.”
“Could you write an article on the utility of investing in Balanced Advantage Funds (BAFs) instead of doing asset rebalancing personally? Won’t the BAFs give broadly similar returns of a 60E:40D/ 50E:50D asset allocation?
The short answer to the reader’s question is never use balanced advantage funds, dynamic asset allocation funds, or any other mutual fund for that matter, as a one-fund portfolio to save on rebalancing costs or tax! Here’s why.
Balanced Advantage Funds have a largely unknown investment strategy. The reasons behind their security selection and asset allocation calls are also unknown. While rebalancing costs and taxes are reduced, the fund management risk is too high to favour such a convenience.
For example, the fund mentioned by the reader is Kotak Balanced Advantage. The levels of corporate bonds in the fund between Aug 2018 to May 2022 have varied from 0.4% to 21.6%. The levels of gilts have varied from 0.7% to 21.5%. Equity allocation is a lot more sedate (to maintain the tax status of the fund), from 63% to 75%. The same is true of bond duration too. In the period mentioned above, the allocation of bonds maturing over 5Y has varied from 2% to almost 22%. Such variations are common to all funds in this category.
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There are too many unknowns and uncertainties in funds of this category to use as the only fund in a portfolio. Also, we have shown earlier a continuous de-risking strategy is essential to reach our goals regardless of market conditions. So while their equity-like allocation is appealing from a taxation point of view, it is not suitable for goal-based investing as a solo fund.
Moreover, there is too much concentration risk in using only one fund for our goal(s) especially when it is actively managed. Any crisis or scam affecting the fund house can result in redemption pressure in the fund.
Therefore it is better to use a mix of equity funds or equity-oriented hybrid funds and fixed income products (including debt-oriented hybrid funds) in a portfolio than to rely on a single hybrid fund. The risks are too high. It would be better to diversify the fund management risk among a few funds and rebalance and reduce equity allocation periodically in a goal-based manner.