Mutual funds are one of the best available tools to invest,that may fulfil your future goals. However, given that there are over 1600 schemes, trying to pick the right mutual fund scheme for an investor can be a tall task.
Some categories of mutual funds are aggressive on equities, others invest only in debt; some have large investments in highly volatile small-caps, others stick to large-caps. In such a scenario, picking one fund is similar to losing another fund’s advantage. However, there is one category of fund that may be a balance between all of these.
Balance Advantage Fund or BAF is a category of mutual funds that could give an investor the best of both worlds – creating wealth as well as protecting capital. The fund invests in equity and debt, based on valuation attractiveness – making the most of market cycles. The broad allocation to equity and debt is based on a set formula. Most fund managers try to keep minimum 65 percent allocation towards equity to provide equity tax benefit to investors. Rest is invested in debt.
This product category allows for both upside participation and managing downside risk that may deliver long term returns, the last 10 years’ data shows. Portfolio is balanced dynamically – with both debt and equity portions being actively managed.
Fund managers usually focus on picking right valuation and keeping emotions at bay when buying stocks. There are few factors more important than valuation and removing biases that makes balanced advantage funds favoured among investors. This approach to investing can also be applied by retail investors when investing in markets.
For any balanced advantage fund, valuation becomesa key factor to decide which sector and stock to pick. It also aims to ensure that one is able tobuy low and sell high, instead of buying high and selling low that most retail investors are prone to doing.
There are two popular valuation ratio that can be used by investors – Price to book ratio (PBR) and price to earnings ratio (PER). PBR uses price of the stock and book value of a company, i.e, the net value of its assets and compare the value against industry as well as historical PBR.
In case of PER, either it can be trailing PER – where price is divided by last one year’s earnings — or forward PER – where price is divided by next one year of expected earnings. Similar to PBR, the ratio is compared against historical and industry PER.
Balanced advantage funds also use another metric called equity risk premium – which is a difference between bond yield and earnings yield. In simple words, this is the excess return earned by an investor when they invest in the stock market over a risk-free rate bond (sovereign bonds).This metric is used to decide how much of a fund should be allocated towards debt.
Eliminating biases
When managing public money, it is important that fund manager is able to eliminate most biases. Biases can be due to different reasons – overconfidence, behaviour, peer pressure, etc. – however, they have significant impact on the performance of any fund and create undue risk.
The best way to eliminate biases is setting up a statistical model and rigorously following that. For instance, one can set up an investment model – employ either top down or bottom-up approach or mix of both when selecting stocks. Use parameters such as PER, PBR and equity risk premium to decide on allocation.
The author is the Head Equities at Canara Robeco Mutual Fund.
Disclaimer: Business Today provides stock market and mutual fund news for informational purposes only and should not be construed as investment advice.