Dynamic Asset Allocation funds – What problem do they solve?

No one wants to lose money. “The pain of losing is psychologically about twice as powerful as the pleasure of gaining.” (Theory of Loss Aversion by Daniel Kahneman and Amos Tversky)

Now, when you invest in stock markets, the sight of near term loss is real. The volatility can come to bite any time. In fact, it does every day the ticker moves.

Having said that, there is a way to minimise the pain using Asset Allocation. Just distribute your assets between equity and debt. Over time, keep rebalancing so that you maintain the allocation. Equity allows you to participate in the upside and debt protects you from a very bad fall.

But this is the problem for investors. Carrying out this operation is easier said than done.

Which begs the question – is there an investment option that can do it for you?

The Dynamic Asset Allocation Fund is probably the answer you are looking for.

What is a Dynamic Asset Allocation Fund?

You already know 2 types of funds – equity and debt. Each of them sticks to its mandate and invests at least 65% in the respective asset class, equity or debt.

The Dynamic Asset Allocation Fund is a hybrid option where the fund is allowed to vary the proportion of equity and debt based on some predefined model.

This model is derived from various fundamental and technical indicators which allows the managers to increase or decrease allocation to equity.

This allows them to avoid big drawdown pains (yes, they do get some pain but not as much as pure equity funds). As an example, when the markets fell over 30% in March 2020, some of the dynamic funds fell just around 10% or less. Nice!

But reducing the drawdown pain can come at a cost. When the markets move up continuously, the models may still be cautious and hence may fall short of market returns.

Come to think of it, it’s a fair deal. They may not give market like returns on the upside, but they cut down on the pain when markets fall.

In summary, this is the big idea of a Dynamic Asset Allocation fund – narrow the volatility of the portfolio and curtail the extent of the drawdowns.

Let’s explore this more.

Not all dynamic asset allocation funds are cut by the same cloth

As per ValueResearch, there are 25 schemes in this category. Each of the funds brings its own touch to the way it functions employing various strategies. The primary difference is in the way the models work. Some are more market valuation driven, others use market valuation as well as momentum.

Let’s look at a few of the funds below.

*HDFC Balanced Advantage fund was a result of a merger between two funds, one of them HDFC Prudence fund. The best period data for this fund has been ignored for now.

All data is for direct plans only. Data source is last available factsheets. Returns data as on April 9, 2020

We are using the worst 1 year performance as the basis of measuring worst drawdowns in any 1 year.

The first 2 funds are the oldest and largest sized funds from the category. The last 3 each are 1/10th the size of any of the HDFC or ICICI funds.

HDFC Balanced Advantage Fund

This is the former HDFC Prudence Fund. In terms of size, it rules the roost as a hybrid fund category. It is managed by none other than Prashant Jain.

HDFC Balanced Advantage is also most aggressive in the dynamic asset allocation category. At the end of Feb 2020 (before the market fall), the fund had 80% allocation to equities.

As you also notice from the image, this fund fell as much as the markets, despite the fact that it had close to 30% in debt. There was no protection of sorts. Your screams on the way down were as loud as the ones from those holding a pure equity fund.

ICICI Prudential Balance Advantage fund

The original practitioner, I think, of dynamic asset allocation is the ICICI Prudential Balance Advantage fund. Some investors swear by this fund! It varies the equity allocation in the fund taking into account market conditions. This allows it to reduce drawdowns in falling markets and benefit from market upsides.

ICICI Prudential MF has its own internal model (based on variety of parameters) for both equity and debt. It is publicly shared as a part of its factsheets. I reckon, the same model is put to use in determining the allocation for equity in this fund too. The fund is managed by the chief star manager, Sankaran Naren.

In our data, you see that this fund was able to reduce the drawdown by at least 1/3rd in March 2020 compared to the market in general. You did feel the turbulence but it was not as if the carpet had been pulled from under your feet.

Edelweiss Balanced Advantage Fund

The fund that really pulls off a feat in the category is the Edelweiss Balanced Advantage Fund. The fund almost sleepwalked out of the market fall (just 7% down against the 1/3rd of the market).

This fund has had a history, in different forms. It was an Absolute Returns Fund until April 2017 when post a merger, it turned itself into a Dynamic Equity Advantage Fund. Post the SEBI categorisation, it took its latest avatar.

The fund has followed more or less a similar strategy over the years – using fundamental and technical indicators weaved into an internal model to determine equity allocations. Edelweiss MF website has all the details about how their model functions.

DSP Dynamic Asset Allocation Fund

This fund comes across as the first correctly named fund scheme from our list. It too varies the equity allocation in its portfolio based on an internal model comprising of various fundamental + technical indicators.

It is interesting to note that the fund was able to contain the drawdown in the portfolio quite well at just 9%.

Note that this fund has the lowest allocation to equities (roughly 63%) compared to other dynamic funds in our list. This points to the fact that each of the models work differently.

Motilal Oswal Dynamic Fund

This fund is one of the latest entrants to this space, started in Sept 2016. This dynamic fund varies its allocations basis the MOVI index, short for Motilal Oswal Value Index, an internally created model by Motilal Oswal.

Using a mix of P/E, P/B and Dividend Yields with a weightage assigned to each factor, the MOVI index signals whether equity allocation should go up or go down. The index is available on their website.

Based on factsheet data, while the fund curtailed the drawdown to just -12% it also moved in aggressively into equities during the fall to rebalance the allocations.

As I mentioned, there are many other funds. We took a few examples to get a good overview of the category spectrum.

Isn’t the Balanced Advantage a different category?

Not really! There is a quite a bit of confusion about the way these words dynamic or balanced advantage are used.

SEBI’s categorisation guide puts Dynamic Asset Allocation / Balanced Advantage as a single category. So, whatever be the scheme name dynamic or balanced advantage, it belongs to this one category.

What is the taxation applicable to these funds?

These funds can operate as standalone equity funds or sometimes as fund of funds.

The examples used above are all standalone ones. They manage their equity component in a way that between equity + arbitrage (which is equity like), they have 65% or more of the portfolio classified as equity and that makes them an equity fund for taxation purposes.

Funds such as Franklin India Dynamic Asset Allocation Fund operates as a fund of funds (FOF). This fund uses a dynamic allocation formula to invest in other Franklin India Schemes, both equity and debt. This FOF structure makes them taxable as debt funds.

Can I just do my own asset allocation and rebalancing?

Of course, you can. In fact, it is highly likely you own different types investments (outside of mutual funds). In that case, you need to observe your asset allocation across investments and rebalance regularly.

If you are in the passive investing camp, where you maintain a low cost index funds and debt funds portfolio, then too you will need to rebalance your holdings on a periodic basis.

One can argue that doing by yourself could lead to an extra tax outgo. Might be true if you use high expense funds. In the case of index funds, low costs may more than set off taxes against savings in costs.

The most important thing is that one needs to be disciplined in asset allocation and rebalancing otherwise it is all going to come to noughts.

For other risk conscious investors, the dynamic asset allocation funds offer a compelling proposition to allow disciplined asset allocation and rebalancing and that too, tax effectively and cost effectively.

Can a dynamic asset allocation fund be the only fund in my portfolio?

Well, why not? It is as simple as it can get. No separate equity or debt, just one fund does the job for you.

To make this work, you must also set your expectations right.

First, you need to have a minimum 3 year time horizon in your mind. Second, the primary benefit you are looking for is lower volatility and not highest returns. That is all.

Stay safe!