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Should you invest in dynamic asset allocation funds?

Dynamic asset allocation funds can invest in equity and debt in any proportion but leaving asset allocation to the fund manager isn't a suitable investment strategy. Here's why.

Should you invest in dynamic asset allocation funds?

Dynamic asset allocation funds or balanced advantage funds are a prominent category in open-end hybrid funds. Funds in this go-anywhere category enjoy the benefit of choosing their asset allocation without any minimum exposure limits to a particular asset class.

Over the past five years, assets managed by the category have grown at a rate of 40 per cent per annum to Rs 95,000 crore (as on November 30, 2020) from about Rs 18,000 crore, thereby making it the second-largest category in open-end hybrid funds based on assets. However, a notable jump in the AUM was noticed in 2018 when some big funds recategorised themselves following the SEBI's reclassification exercise (see the graph 'Growing assets').

What are dynamic asset allocation or balanced advantage funds?
Funds falling into this category usually invest in debt, equity and arbitrage opportunities. Since they don't have any minimum allocation limit, they can decide their equity-debt allocation based on market conditions, equity valuations and other factors that the investment management team considers important. Thus, on paper, these funds can have 100 per cent debt allocation and vice versa. However, each fund in the category maintains some minimum allocation limits, which are stated in the scheme information document. Also, most funds use the arbitrage component so as to leverage the benefit of equity taxation.

How are they managed?
A true-to-label dynamic asset allocator should ideally be able to change its asset allocation over a period of time in such a way that when the equity markets are at lower levels, it is able to increase its equity allocation to benefit from an expected rally and when the markets are at their highs, it should allocate more to debt securities to contain the downside if the markets fall.

No doubt, the mandate of managing asset allocation dynamically sounds great. However, in reality, it can be difficult to follow. Results can be disappointing for an investor if the fund gets wrong-footed while timing its asset-allocation shifts. Moreover, since there is no predefined limit on the minimum allocation requirement of each class, the decision of deciding the right asset allocation mix is left to the discretion of the investment management team. Therefore, the asset allocation in this category varies from fund to fund. A look at the portfolios of the funds in this category shows that over the past three years, while some funds have maintained the equity-debt allocation in a narrow range, the asset allocation of some funds has oscillated to the extreme levels, with net equity of a fund varying from as low as 2 per cent to as high as 94 per cent. Thus, although some funds in this category are true to their label, many are managed with a rather fixed asset allocation.

The graph 'Contrasting allocation' shows wide differences in the asset allocation pattern of different funds in the category in any given month (see the lines for maximum and minimum net equity allocation). Thus, at any given point of time, while one fund in the category has net equity allocation as high as 98 per cent, the other one has net equity as low as 6 per cent.

This means that the risk-reward profile of funds in the category also varies significantly. The graph 'Performance variation' shows the maximum, median and minimum returns given by these funds in any three-year period.

Does it make any sense to invest in these funds?
Although the unconstrained investment mandate of these funds may look appealing, we, at Value Research, are usually wary of recommending these funds, as dynamically moving across debt and equity may often require taking a call on the market. We believe that it is fairly difficult, perhaps next to impossible, to get it right on a sustainable basis. On the contrary, we prefer static asset allocations based on one's investment horizon.

For instance, a conservative long-term investor can opt for aggressive hybrid funds which maintain a 75:25 allocation between equity and debt and rebalance regularly to stay close to that kind of asset mix. Likewise, a fixed-income investor looking for only a small dose of equity can go for a conservative hybrid or equity savings fund. Since an investor can predict where such funds lie (and will remain) on the risk-return spectrum, he can decide whether the asset allocation of these funds suits him or not, depending on factors like his investment horizon, risk appetite, etc.

Although it is advisable to invest in a combination of debt and equity, leaving the asset-allocation decision to the fund manager is not a suitable strategy. Nevertheless, some dynamic asset allocation funds have been following a pragmatic, number-driven approach to asset allocation with a fair degree of success. A pragmatic and methodical approach prevents them from taking arbitrary, judgemental calls on the market, which can backfire in a big way and helps them manage asset allocation more efficiently through ups and downs of the market.

However, as mentioned above, we are in favour of the funds that come with a more static asset allocation. We believe that a static but disciplined approach to asset allocation is more effective in delivering intended results over the long term and therefore, help you achieve your investment objectives, provided it is suited to your goals and investment horizon.