How dynamic asset allocation funds are ideal for those who worry about market volatility

24 May 2019

While equity is the best performing asset class in the long term, it is also one of the most volatile asset classes. A big stock market crash can wipe out several years of the investor’s accumulated gains. Fixed income (debt), on the other hand, is more stable but gives lower returns. Investors should give a lot of importance to asset allocation in order to protect their portfolio from downside market risks and at the same time, achieve their long term objectives.

Hybrid mutual funds are great tax efficient investment options for investors to get optimal asset allocation in their investment portfolios. There are several types of hybrid mutual funds ranging from aggressive equity oriented hybrid funds (earlier known as Balanced Funds), which maintain a high equity exposure (65 – 80%) to conservative debt oriented hybrid funds, which have low equity exposures (10 – 25%). While aggressive hybrid funds can give high returns in the long term, they are also exposed to high volatility (albeit lower than pure equity funds). On the other hand, conservative hybrid funds provide considerable downside protection (due to high fixed income exposure) in volatile markets, the returns are lower.

Read what are Hybrid Aggressive Funds

Dynamic Asset Allocation Funds, also known as Balanced Advantage Funds which actively manage equity and fixed income exposures depending on market movements, are ideal investment options for investors who want good returns and at the same time, desire stability in their portfolios.

If equity valuations are high, during stock market rallies, dynamic asset allocation fund rebalances its asset allocation by decreasing its equity exposure and increasing its fixed income exposure. Dynamic asset allocation lowers the risk profile of the fund – limits downside risk in volatile markets. If equity valuations are low, during market corrections,these funds increase their equity exposure and lower fixed income exposure. The active equity exposure as per dynamic asset allocation models can range from 30% to 80%, depending on the prevailing market conditions.

How Dynamic Asset Allocation Funds work?

Dynamic Asset Allocation Funds or Balanced Advantage Funds essentially work on the age old investing principle of “buying low and selling high”, in other words these funds will buy stocks (and sell fixed income securities / bonds) when stock prices are low and sell stocks (and buy fixed income securities / bonds) when stock prices are high. Different Balanced Advantage Funds use different dynamic asset allocation models, but the underlying principle in all are “buying low and selling high”.

Some Dynamic Asset Allocation Funds use Price to Earnings ratio (P/E ratio) or Price to Book ratio (P/B ratio) of Nifty / other indices to determine asset allocation based on a specific mathematical models developed by the respective AMCs.When the stock market rallies, stock prices usually races ahead of earnings growth – this causes the P/E ratio to increase, in other words, valuations get expensive. Stock prices may continue to rally as long as earnings growth expectations are good. When the earnings growth slows down due to economic downturn, stocks look risky and investors dump them to invest in safer assets like Government bonds,causing stock prices to crash and losses to equity investors.

A dynamic asset allocation fund continuously rebalances its asset allocation from equity to debt when market rises and P/E or P/B ratio gets richer. When the P/E ratio is at a high, during market peaks the asset allocation of these funds is heavily skewed towards fixed income. As a result when the market crashes, the downside risk is limited.

In deep market corrections or bear markets, when stock prices continue to fall, the high fixed income allocation of Dynamic Asset Allocation Funds or Balanced Advantage Funds generates interest income (yields) for investors and provides stability to their portfolios. Past experience tells us that price cuts in bear market are very sharp – as prices continue to fall, the P/E ratios decreases and stocks become less expensive.

Check the Trailing Return of Dynamic Asset Allocation Funds over the last 5 years

In the stock market, at this stage, investors try to cut their losses by selling. As market continues to fall, panic sets in among investors and each fall brings a bigger fall. Balanced Advantage Funds, on the other hand, take advantage of this fall to methodically rebalance their asset allocation from fixed income to equity. When the bear market is near its bottom and there is pessimism all around, valuations (P/E ratios) move from the expensive zone to the cheap zone. Depending on market conditions, if P/E ratios have fallen substantially, the asset allocation of Dynamic Asset Allocation Funds or Balanced Advantage funds may be skewed towards equity. High allocation to equity near bear market bottoms, positions these funds strongly to take advantage of the market recovery.

Some Dynamic Asset Allocation funds use yield gaps, difference between earnings yield of Nifty / other indices and yield of Government bonds (e.g. the 10 year bond), to determine asset allocation. Earnings yield of Nifty is essentially the reciprocal of Nifty valuation (P/E). Wider the yield gap, higher is the allocation to equities. As yield gap narrows, these funds rebalance their asset allocation from equity to fixed income and vice versa. There can be other variants of dynamic asset allocation strategies, but in all strategies, Dynamic Asset Allocation Funds are essentially buying low (in bear markets) and selling high (in bull markets). However, they are doing it in a systematic way based on a back-tested mathematical model, instead of trying to time market based on price outlooks.

Did you know which are the top Dynamic Asset Allocation Funds

Taxation

Most Dynamic Asset Allocation Funds enjoy equity taxation. How do balanced advantage funds ensure equity taxation even when the model suggests low equity exposure? The net equity exposure of balanced advantage is reduced not only by shifting allocation to debt (up to maximum 35%), but also through hedging using derivatives. Hedging through derivatives allows the funds to have minimum gross equity exposure of 65%, while reducing risk at the same time. Further, hedging also enables the fund to generate arbitrage (risk free) income which can supplement the income from debt securities. If you want to avail equity taxation, you should consult with us about the tax treatment of individual Dynamic Asset Allocation Funds.

Conclusion

In this article, we discussed how Dynamic Asset Allocation Funds are ideal for investors who want to minimize the effects of volatility on their investment and at the same time, want good returns in the long term. As per its recent circular with regards to categorization of mutual fund schemes, SEBI has defined a separate category for Dynamic Asset Allocation Funds or Balanced Advantage Funds, making it simpler for investors to identify such funds and evaluate different options before investing. You should consult with your financial advisor, if Dynamic Asset Allocation Funds are suitable for your investment needs.

Suggested reading: What is the best mutual fund according to your risk appetite?