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The Magic Formula Behind Dynamic Funds

This type of fund brings an interesting element into equity fund investing

Recently, two fund companies have launched schemes that of a type that are called 'dynamic' funds in the fund industry. The word dynamic here has a slightly different meaning than it does in everyday life. It doesn't mean have a go-getting kind of personality, nor does it mean that the fund manager necessarily has that kind of a personality. It just means that the fund can shift its asset allocation widely between equity to debt and any combination thereof. In contrast, practically all other funds are contained by design within a fairly precise border of equity and/or debt.

However, dynamic funds often have another interesting characteristic. The balance between debt and equity is decided not by a fund manager, but by a formula. To be sure, this is not passive investing as in an index fund because the recipe for asset allocation is itself a result of research by the fund house, but there is an element of automation involved. These two new funds are Principal SMART from Principal Mutual Fund and Pramerica Dynamic Fund from the new company Pramerica. Of the dynamic funds that exist earlier, Franklin Templeton's FT India Dynamic PE Ratio, ING's OptiMix Asset Allocator and UTI's Variable Investment Fund are formula driven while the asset allocation in SBI's Magnum NRI FlexiAsset is decided by the fund manager.

For example, Principal SMART will stay entirely in equities while the Nifty's PE will be below 16. At higher levels, the equity exposure will be reduced gradually till the fund becomes a pure debt fund at Nifty PEs of 28 and above.

The goal is always to use indicators like PE ratio and others to define a time when the markets are ready to fall and to reduce equity allocation at that time and to increase it when the markets have fallen enough. Either way, this type of fund brings an interesting element into equity fund investing. Normal equity funds are always supposed to be invested in equities. Conceptually, then, their job is to do better than the equity markets. Whether they say it so explicitly or not their job is not to make gains but to do better than their benchmark, even if that means falling less than the markets when the markets are falling.

Dynamic funds, on the other hand, implicitly make the promise of being absolute return funds. They define their job as making gains with their equity investments just like non-dynamic equity funds, but additionally as also getting out of equities when the markets are not going to do well.

This column first appeared in The Economic Times on December 13, 2010