Mutual fund investors have long been told that they shouldn't try to time the market. SIP or Systematic Investment Plan is the ideal option for them. But when you have a lumpsum amount that you have to invest in one go, it's important to consider current market valuations. So, if you want to invest when market valuations are not cheap, the risk of correction always looms large. For conservative investors, the biggest worry is sharp swings in the market, especially on the way down! This worry often totally holds them back from investing. To bridge this gap, fund houses have been launching products that use models to buy equities when valuations are low, and sell them when they become expensive. This week Axis Mutual Fund has announced the launch of Axis Dynamic Equity Fund, an open-ended equity scheme, that does not maintain a fixed allocation to equity but instead uses a systematic rule-based model to dynamically adjust its equity allocation over time.
Let us find out how Axis Dynamic Equity Fund aims to take asset allocation decision and how different is it from peers.
Axis Dynamic Equity Fund aims to have a net equity allocation between 30-100% of the portfolio. The fund will use hedging to reduce net equity exposure below 65%, so that the fund continues to enjoy equity taxation. The allocation to debt is the residual number that is arrived at after deciding the equity and derivative allocation.
Once the Axis Dynamic Equity Fund model decides the equity allocation, the fund manager, would then construct a multi-cap portfolio made on a bottom-up basis. The role of the model is limited to deciding the equity allocation only and the portfolio is actively constructed by the fund manager. The asset allocation decision is to be reviewed on an on-going basis (once every two months) and is dynamically linked to movements in market variables.
By isolating the different variables that affect the market in the medium term and by systematically adjusting exposure to deal with them, the fund is aiming to consciously manage the market risk. Such an approach may make it likely that such a fund will lag the equity market during a sharp rally. However, it should also allow the fund to reduce drawdowns during periods of turmoil and consequently help deliver reasonable equity exposure with sharply lower risk over a cycle.
Two major things investors must notice for all dynamic equity funds are turnover and taxation. Given the nature of such schemes, the portfolio turnover ratio at times could be very high. While balanced funds maintain a steady exposure to equity and debt, dynamic asset allocation funds switch aggressively.
Dynamic funds that invest in other funds (thus making them fund of funds) are classified as 'non-equity' schemes and their taxation status is the same as that of debt funds. Whereas, dynamic funds which directly invest in stocks, get the same tax treatment as equity funds if their average equity exposure in the past 12 months is at least 65%.
How peers do it
There is a motley mix of funds that use their own model or system to decide asset allocation. Practically, everyone is trying to do the same thing -- buy more stocks when markets are down, and avoid equities when markets are euphoric. When they avoid equities, they buy more of fixed-income. But the route taken by such funds are different.
The Rs 19,000-crore+ ICICI Prudential Balanced Advantage Fund was one of the first to make investing easy and less stressful, by allocating between different investment options as per changing market conditions. The fund aims to generate low volatility returns by investing in a judicious mix of cash equities, equity derivatives and debt markets. The usage of equity derivatives in this fund is intended to hedge the portfolio against the downside risks, thereby allowing it to generate low volatility returns. This way the fund aims to provide better returns than typical debt instruments and lower volatility in comparison to equity.
Guided by PE ratio
Some schemes dynamically follow a Dynamic Price to Earnings (PE) Ratio Model. For instance, HDFC Dynamic PE Ratio Fund of Funds allocate its assets between equity schemes and debt schemes based on the 1-year forward PE ratio as per the Bloomberg Consensus estimate of NIFTY 50. When the 1-year forward PE ratio is between 0-12, the fund invests 90-100% money in equity schemes. When the ratio is greater than 12 but less than 16, equity schemes get 70-90% and debt schemes get 10-30%. This allocation band changes as the PE ratio rises. When the ratio is more than 30, debt schemes get 90-100% of money. PE ratios are reviewed on a monthly basis and the portfolio is rebalanced accordingly.
Franklin India Dynamic PE Ratio Fund of Funds also adopts a similar strategy. The equity component is invested in Franklin India Bluechip Fund or Franklin India Prima Plus. The debt component is invested in Franklin India Short Term Income Fund or Franklin India Income Opportunities Fund. It has a predefined monthly rebalancing mechanism based on the PE level of Nifty 50. Hence, the fund reduces equity exposure and increases debt exposure when PE levels are high and vice versa.
L&T Dynamic Equity Fund uses an asset allocation model to helps investors benefit by dynamically changing net equity allocation based on P/E. It does so by managing the allocation across unhedged equity, hedged equity, debt, and money market instruments.
In case of Principal Smart Equity Fund, this scheme too decides on allocation of funds into equity assets based on equity market Price Earning Ratio (PE Ratio) levels. When the markets become expensive in terms of 'Price to Earnings' Ratio, the scheme reduces its allocation to equities and move assets into debt and/or money market instruments and vice versa.
The Kotak Asset Allocator Fund, another fund of funds, determines the equity allocation based on a combination of 3 criteria, namely, trailing PE ratio of CNX Nifty, analysis of yield gap (ratio of yield on debt to earnings yield of equity) & momentum (by using metrics like 200-day moving average & MACD of CNX Nifty).
The IDFC Dynamic Equity Fund previously used to base its strategy on two factors. Its model was dependent on month-end weighted average PE Ratio and 200-days moving average (DMA). From mid-June, the fund tweaked its quantitative model and now fund managers take equity exposure depending on opportunities available at various points in time based on the month-end weighted average PE ratio only. Lower the PE band, higher the equity allocation (and lower debt allocation).
The ICICI Prudential Dynamic Plan invests primarily in equities and, for defensive consideration, in a mix of equity and/or fixed income securities including money market instruments. The actual percentage of investment in equities and fixed income securities is decided after considering the prevailing market conditions, the macro economic environment, the performance of the corporate sector, market liquidity, and other considerations in the economy and markets. It has the discretion to take aggressive asset calls, i.e., by staying 100% invested in equity market/equity-related instruments at a given point of time and 0% at another, in which case, the scheme may be invested in debt-related instruments at its discretion.
Pramerica Dynamic Asset Allocation Fund uses Pramerica DART, a proprietary model. The fund house says that DART analyzes key lead indicators to evaluate the relative attractiveness of the equity markets at a particular point of time. Under normal market conditions, the exposure to equity and equity-related securities in the scheme would range from 30% to 100% of the scheme's portfolio. Of that, at least 60% would be invested in equity and equity-related instruments of large-cap companies.
Motilal Oswal MOSt Focused Dynamic Equity Fund's allocation is based on Motilal Oswal Value Index (MOVI) which is calculated taking into account Price/Earnings, Price/Book and Dividend yield of Nifty 50 Index. A low MOVI level indicates that the market valuation appears to be cheap and a high MOVI level indicates that the market valuation appears to be expensive.