As far as mutual fund investors were concerned, Budget 2006-07 was on expected lines. There was a long-pending move to strike parity between open-ended and close-ended equity funds. There were a couple of proposals to allow greater flexibility to equity funds to invest abroad. A major negative came in the form a change in the tax status of balanced funds as they exist today.

This seemingly docile budget proposal has far-reaching implications for the mutual fund industry and investors. In effect, the budget has called for a change in the definition of balanced funds to coincide with that of SEBI's (Securities and Exchange Board of India) definition. In other words, mutual funds with a minimum 51% equity component will no longer qualify as balanced funds or equity-oriented funds. Now they will need to maintain a much higher (minimum) 65% equity component to qualify as balanced funds.

Why would fund houses be interested in pursuing the option to alter their balanced funds into a 65:35 (equity:debt) offering? Equity-oriented funds are considered securities and attract tax benefits that are similar to those on stocks. So dividends declared by equity-oriented funds are tax-free and there are no capital gains on equity-oriented funds, rather you pay a Securities Transaction Tax (STT) on redemption.

By defining a minimum 65% equity component for equity-oriented funds, the finance minister has compelled fund houses to take a re-look at their balanced fund offerings. Fund houses that want to benefit from the tax laws for equity-oriented funds will necessarily have to up the equity allocations in their balanced funds. Those fund houses who do not wish to disturb their traditional 60:40 balanced fund, may well consider launching an aggressive balanced fund that can go upto 65% in equities. Our interaction with various fund houses indicates that there are candidates for both options, i.e. some fund houses may change the mandate of their existing balanced fund so that it can invest upto a minimum of 65% in equities, while some fund houses may continue with their existing balanced fund (with a typical 60% equity component) and launch an aggressive balanced fund that can invest a minimum 65% in equities. Of course, when fund houses increase the equity component of their balanced funds, existing investors will have the option to redeem their investments in those funds.

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  Consciously or otherwise, the budget proposal to redefine equity-oriented funds has actually spawned a new balanced fund category, the aggressive balanced fund. In a bid to complete their product offering, fund houses will ensure that they have both conservative and aggressive balanced funds. So investors can expect another surge of NFOs (new fund offerings) of the balanced fund variety. At a time, when the need of the hour is to reduce complexities and simplify product offerings, this is exactly what the investor does not need.

  There is an aspect to the definition of equity-oriented funds that is quite disturbing. According to SEBI's definition, an equity-oriented fund must have a minimum 65% equity allocation at all times. This implies that balanced funds cannot afford to have their equity allocation fall below the minimum 65% limit even for a day if they want to retain their tax status. In effect balanced funds will actually aim for an equity component much higher than the minimum 65% as a security against a sharp fall in stock markets on a particular day that could pull down their equity allocation below the 65% mandatory limit. So don't be surprised if you find balanced funds with 70% equity components. In Personalfn's view, a fund with a 70% equity allocation is hardly a balanced fund; it's more of an equity fund!

  Even some diversified equity funds and disciplined value funds that hold large amounts of cash for strategic reasons or due to lack of investment opportunities will have to ensure that they are invested in equities upto a minimum of 65%.

  In our view, the step to redefine balanced funds needs further consideration. It appears like just another proposal, but actually calls for a major shift in asset allocation and could tempt investors into opting for aggressive balanced funds without having the appetite for it. Fund houses on the other hand, will be compelled to take on higher risk which will only blur the lines between their balanced funds and existing diversified equity funds. All in all, we see a lot of confusion and unwarranted risk being taken by both fund houses and investors to comply with SEBI's definition of equity-oriented funds.

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