In investing, you’ll come across the concept of asset allocation. This refers to how your money is distributed across various asset classes like equity, debt, gold, real estate, and cash. Now, when we add the term ‘dynamic’ to asset allocation, it means the mix changes over time based on how the market is performing. So let’s go over what dynamic asset allocation is and understand how this strategy works in mutual funds.
What is Dynamic Asset Allocation?
In investing, dynamic asset allocation refers to a strategy where fund or portfolio managers adjust the balance between different types of investments, like stocks, bonds, real estate, gold, or cash based on prevailing market conditions. If the circumstances favour equities, managers invest more in stocks. If the conditions are bearish, they reduce equity exposure and shift more money into safer debt assets.
This investment approach is commonly employed by mutual fund managers and professionals offering portfolio management services. Through extensive research, predictive models, and value assessment, these experts alter the exposure to different asset classes to protect the portfolio from downside risk and take advantage of opportunities as they come. Basically, instead of sticking to a rigid structure, managers adapt the mix of assets from time to time, making this approach a very active form of investing.
Dynamic Asset Allocation Funds
When looking at mutual funds, you may have come across categories of funds called Dynamic Asset Allocation Funds or Balanced Advantage Funds. Both terms are used interchangeably as they refer to the same type of fund. BAF or dynamic asset allocation fund meaning can be understood as a type of mutual fund where managers adjust their mix of equity, derivatives, and debt depending on market conditions.
According to SEBI, BAFs are one of the seven categories under the hybrid fund classification in mutual funds. They are defined as funds that dynamically manage their allocation between equity and debt instruments, so there are no strict limits or fixed ranges on how much they must invest in either asset class at any given time. For example, a multi-asset allocation fund must invest in at least 3 different asset classes with at least 10% allocated to each. Similarly, in another hybrid category fund, the equity savings fund, the equity exposure (including arbitrage) must be kept above 65%.
Dynamic asset allocation funds enjoy full flexibility, so technically the managers can invest anywhere between 0%-100% in equity and equity-related instruments, and 0%-100% in debt instruments. An sip investment planner might recommend such funds to investors with a moderate risk appetite looking to achieve goals in the mid or mid to long-term.
How Does Dynamic Asset Allocation Work?
Dynamic asset allocation is all about how one responds to the changes in market conditions. For individuals, portfolio allocation depends on risk tolerance. They aim to adjust their portfolios to accurately reflect their financial conditions and market outlook. For example, let’s say the equity-to-debt ratio for an individual with a high-risk tolerance is 80:20. After a year the ratio shifts to 70:30, so an Financial planner advises the investor to bring the allocation back to the original. For the most part, the asset allocation here is rigid. Things change with dynamic asset allocation. Here, the aim is to capture momentum by selling underperforming and undervalued assets and taking advantage of market shifts to earn higher returns, even if it means changing the allocation significantly.
For instance, let’s assume a dynamic asset allocation fund invests 35% in equities, 30% in derivatives, and the rest in debt instruments in 2023. After two years, the allocation changes to 50% in stocks, 15% in derivatives, and 35% in cash and debt. The reasons for such a shift could include stock undervaluation and equity momentum. Managers and research analysts use a variety of dynamic asset allocation strategies, financial models, formulas, and historical analyses to ensure the portfolio reflects the market conditions.
Features of Dynamic Asset Allocation Funds
- Active Management: Managers handling dynamic asset allocation funds are very active as the fund’s success depends on how well they respond to changing market conditions.
- Flexibility: Unlike other hybrid funds such as equity savings schemes or multi-asset allocation funds, there are no fixed limits or minimum thresholds in a dynamic asset allocation fund for how much must be invested in equity or debt.
- Risk Management: A core aspect of BAFs is that managers are quick to move on from overvalued or excessively volatile components. For example, managers reduce equity exposure and shift to safer debt or arbitrage opportunities to reduce risk.
- Tax Efficient: Almost all BAFs in the market are taxed like equity-oriented schemes, so they enjoy lower tax rates and a Rs. 1.25 lakh exemption on long-term capital gains. However, it should be noted that some funds in the category are debt-oriented and attract either higher tax rates or require longer holding periods to qualify for equity-like taxation. You’d be wise to consult with a tax planner to understand these intricacies better.
- Higher Transaction Costs: Naturally, a higher frequency of trades in dynamic portfolio allocation causes higher transaction expenses.
- Higher Expense Ratios: Generally, dynamic asset allocation funds come with higher expense ratios due to active management and high transaction costs.
Dynamic Asset Allocation Strategies
Fund managers use different kinds of dynamic asset allocation strategies, including:
- Valuation-based Strategies: Managers buy equity assets when they are undervalued and reduce exposure when they’re overvalued.
- Momentum Investing: Managers aim to capture the momentum by riding the market wave rather than going against it.
- Model-driven Strategies: Advanced financial models are employed to get optimal asset allocation for a given period.
Benefits of Investing in Dynamic Asset Allocation Funds
- Diversification: By investing in a fund with dynamic portfolio allocation, you gain exposure to a variety of assets such as equities, derivatives, debt instruments, REITs, and cash. A diversified portfolio helps reduce risk in case some investments don’t turn out as expected.
- Better Performance: Since dynamic asset allocation funds work on the concept of momentum, managers invest more in equity when the market is doing well and reduce exposure when the market looks expensive or volatile.
- Good For Mid and Mid To Long-term Goals: These funds are a good option for medium to long-term goals such as buying a car or planning a child’s higher education. Still, you should seek guidance from an online financial advisor india to get more personalised recommendations.
- SIP Option: Like other mutual funds, one can invest in BAFs through SIP and make fixed, regular contributions to slowly build wealth.
That said, there are some limitations to these funds as well. The fund’s performance is highly dependent on the expertise of the fund manager, so they often employ research teams which brings managing costs up. Similarly, more transactions within the portfolio mean higher costs, so both these factors contribute to BAFs having slightly higher expense ratios.
Comparison: Dynamic vs. Other Asset Allocation Funds
Funds follow specific kinds of asset allocation strategies. Let’s compare a dynamic asset allocation fund with two such options within the hybrid category: a multi-asset fund, and an aggressive hybrid fund.
| Factor | Dynamic Asset Allocation Fund | Multi-Asset Fund | Aggressive Hybrid Fund |
| Asset Allocation | The portfolio is mainly allocated to equity and debt, and this mix dynamically changes based on market conditions. | These funds invest in at least three asset classes (like equity, debt, and gold), with a minimum of 10% allocated to each class. | At least 65% to 80% of the AUM is invested in equity and equity-related instruments. |
| Management Style | Funds are managed actively and there are frequent shifts in allocation depending on market conditions. | Active management across all asset classes, but rebalancing is not as frequent as BAFs. | These funds are also actively managed, but within SEBI’s fixed allocation guidelines. They are also not as reactive to market shifts as BAFs. |
| Risk Profile | Risk depends on equity/ debt allocation. They usually cater to investors with moderate to high risk tolerance, but funds with high debt investments can be attractive to conservative investors as well. | Suitable for investors with a moderate risk appetite as the portfolio is diversified across multiple asset classes. | Volatility is higher than dynamic or multi-asset funds due to consistent equity-heavy exposure. Since these are more suited for the long term, a retirement planner may recommend them to investors with moderate to high-risk profiles. |
| Tax Treatment | BAFs or dynamic asset allocation funds are treated as equity-oriented if average equity plus arbitrage are greater than 65%. Otherwise, they are taxed like debt funds. | Multi-asset funds qualify for equity taxation if their equity holdings cross the 65% threshold. | Aggressive hybrid funds always qualify as equity-oriented, so LTCG is taxed at 12.5% beyond the Rs. 1.25 lakh exemption. |
| Expense Ratio | Costs can be moderate to high due to frequent buying and selling and funds employing bigger research teams. | Moderate costs. | Moderate to high expense ratios. |
How to Invest in a Dynamic Asset Allocation Fund?
Investing in a dynamic asset allocation fund is not very different from investing in any other mutual fund. First, you assess your financial profile and goals to understand whether investing in these funds would suit you at all. Then, you can decide between investing a lump sum amount or taking the SIP route. The investment can be started through brokers, mutual fund distributors, or via the AMC directly.
Comparing Funds
Compare funds based on factors like the AMC’s reputation, AUM, historical returns, fund manager’s track record, expense ratio, and risk-adjusted returns to make an informed choice. It is incredibly important to understand how each fund manages its asset allocation. You can study factsheets of various funds to check their asset allocation over the last 3 or 5 years. BAFs that have historically invested heavily in equities would have comparatively higher returns but they would also come with greater risks. Also, always check if the fund has consistently maintained at least 65% allocation to equity and arbitrage, as this affects how your returns will be taxed. Some funds can qualify as equity-oriented even if their average holdings do not cross a specific threshold, but their holding period must be longer than others for them to be taxed as equities. As this can be complex for novice investors, consulting a professional tax consultant can help you understand the implications better and avoid unexpected tax liabilities.
At the end of the day, the best dynamic asset allocation fund is one that matches your risk tolerance, goals, and investment horizon. You can search for an investment consultant near me and speak with a qualified professional who can guide you through the entire process and provide you with regular advice once the investment is made.
Conclusion
Dynamic asset allocation is a strategy in which portfolios are adjusted regularly based on changing market conditions. Managers of dynamic asset allocation funds tend to shift allocation between equity, debt, arbitrage, REITs, or other instruments depending on factors like market valuation, interest rates, geopolitical events, etc. They increase equity exposure when the market is on the up, or reduce it and lean more towards debt to protect capital when valuations are high. This aims to capture momentum and also helps manage risk.
FAQs
Q1: What is the meaning of dynamic asset allocation fund?
A dynamic asset allocation fund, also known as a balanced advantage fund, is a type of hybrid mutual fund where fund managers change the mix of equities and debt in the portfolio based on market conditions to take advantage of undervalued assets and manager risk.
Q2: What are the advantages and disadvantages of these funds?
Advantages Of Dynamic Asset Allocation Funds
- Your money is actively managed by experienced fund managers.
- The portfolio is well-diversified, consisting of a mix of equity, debt, and arbitrage components.
- Managers can adjust the equity and debt exposure based on market conditions to manage risk.
- They are a good fit for moderate-risk investors looking to achieve goals in the medium term.
- Most funds in the category aim for equity-like tax treatment on capital gains, which are taxed at lower rates. However, you should carefully study their historical allocations as some BAFs can fall short of the 65% equity threshold for qualifying as an equity-oriented fund.
Disadvantages Of Dynamic Asset Allocation Funds
- Returns heavily depend on the skill of the fund manager as these funds are very actively managed.
- Comparisons of different funds within the same category can be quite tough as asset allocation between debt and equity can vary wildly.
- Expense ratios are comparatively higher due to active management and frequent buying and selling of assets.
Q3: Who should invest in dynamic asset allocation funds?
Dynamic asset allocation funds are generally suitable for investors with a moderate tolerance for risk who are looking to achieve their financial goals through an adaptable investment approach over the medium term.
Q4: What strategies do these funds follow?
Dynamic asset allocation funds follow quantitative strategies such as valuation and risk assessment, predictive modelling, trend analysis, and risk parity, as well as qualitative strategies like how well managers can judge market conditions and make decisions.
Q5: What are the tax implications?
Capital gains from a dynamic asset allocation fund are taxed depending on the investment’s holding period and asset allocation. Most funds aim to keep equity and arbitrage in the portfolio over the 65% threshold to qualify as equity-oriented funds, which enjoy better tax rates on LTCG. However, some funds may not allocate a sufficient amount to equity-related instruments and thus fail to qualify for equity tax treatment. It is extremely important to assess the fund’s allocation history as debt-heavy portfolios can significantly increase the tax liability for the investor.
