Will balanced funds deliver steady income?

Till a couple of years ago, the regular income seekers would turn towards fixed income options such as small saving schemes, fixed deposits and bonds. Things changed with the introduction of monthly dividend option in balanced mutual funds. There has been tremendous interest in these schemes as interest rates on traditional options fell. In 2017 itself, a large number of conservative investors including senior citizens chose to invest in balanced funds for steady income.

But in the first quarter of 2018 there has been a substantial change which investors can’t ignore. The much-dreaded long term capital gain tax was reintroduced at the rate of 10% in the Budget, along with dividend distribution tax on dividends at the rate of 10%.

This warrants a key question: Will balanced funds deliver steady income? Let us find this out:

Balanced schemes do not guarantee steady income in the strictest sense. They invest at least 65% in stocks. Investments in stocks may result in higher return in comparison with bonds in the long term but the volatility in stocks in the short term may lead to losses. Though the markets are expected to fall, the fund managers cannot short stocks. This may bring down the scheme’s overall return and influence the quantum and frequency of the dividend payouts. If you are comfortable with volatility, then you can remain invested in balanced funds.

But do not overlook the change in taxation. Earlier rules ensure that your long term gains and dividends were tax-free in nature.

Proposition of 10% tax on both, reduce the post-tax return to that extent.

Besides the reduced post tax returns after introduction of new tax rules, balanced funds also have high expense ratio. It could be around 2.25%. In comparison a typical short-term bond fund charges you around 0.75%.

Thus, the bond component of a balanced fund is charged higher. This reduces the post-expense return on the bond component of balanced fund in comparison with the post-expense return on the short term bond fund.

If both bond portfolios offer yield of 8%, then the post-expense yield of the bond portfolio of balanced fund works out to 5.75%, whereas the same stands at 7.25% in case of the short term bond fund. With the introduction of dividend distribution and long term capital gain taxes make the returns unattractive in comparison with the earlier returns which had no dividend distribution and long term capital gain taxes.

If you are not comfortable with this new reality, it is time to look for some other options. Opt for a combination of multi-cap funds and bond funds. Invest your money in accrual focused bond funds and sign up for a systematic withdrawal plan (SWP). SWP helps you withdraw a fixed amount of money at regular interval--weekly, monthly or quarterly. The money invested is expected to earn returns in line with other fixed income instruments. And such withdrawals are subject to capital gains tax norms.

The return kicker comes from the money invested in multi-cap funds. These funds invest money in shares of companies of all sizes.

The fund manager decides allocation to large-cap and mid-cap depending on various factors which include growth opportunities, valuations and overall market sentiment. Such funds should be tapped through Systematic Investment Plan (SIP) with a five-year investment time frame. As you have the long investment horizon, the volatility works in your favour.

Simply going by benchmark indices, the multi-cap space has delivered approximately 18% returns over the past five years. It is reasonable to expect 12% to 15% compounded annual returns from multi-cap funds in the long term.

The allocation between bond and multi cap funds should be decided after taking into account your income requirements, risk tolerance and investment horizon. Given the dynamic nature of developments in markets, you should re-balance asset allocation every year.

(The writer is Head – Investment Advisory at Motilal Oswal Private Wealth Management)