A dynamic asset allocation vehicle
Diversification is one of the key tenets of prudent financial planning. This means investing across asset classes suchas the primary ones, equity and debt, to reduce the risks associated with each class. The risk or volatility of eachindividual asset class can be seen in Chart 1 below.
Most investors, however, may not have the wherewithal to invest across theseasset classes based on market developments. Instead they can look at assetallocation mutual funds to derive the benefits of professional management of theirmoney. Within asset allocation funds, investors can consider balanced advantagefunds (BAF) or dynamic asset allocation funds as a category, which dynamicallyincrease or decrease their equity and debt allocations to optimise risk-adjustedreturns. Additionally, they also hedge a portion of their equity positions byinvesting in derivatives to reduce the overall risk to their portfolio and to maintaintheir overall equity exposure above 65% to qualify for taxation as equity funds.
Dynamic asset allocation
According to the new classification of mutual funds by market regulator,Securities and Exchange Board of India (SEBI), BAFs are hybrid funds where theinvestment in debt, equity and equity derivatives is managed dynamically. Unlikeindividual investors who may be swayed by emotions while responding to market movements and allocating assets between equity and debt, fundmanagers of BAFs use various quantitative criteria to switch from one asset class to another based on valuation metrics such as price-to-earnings (P/E)or price-to-book (P/B) multiples or dividend yields. Some funds use proprietary quantitative models to reallocate assets. Hence, these funds typicallyincrease the equity exposure when valuations are low and decrease it when valuations become frothy.
These funds have shown steady performance beating both the hybrid funds benchmarks and pure equity market benchmark. An analysis of the returnsof BAFs across various time periods shows that while the performance varies widely from fund to fund, on an average the category has out-performedthe debt-oriented conservative hybrid index (CRISIL Hybrid 85+15 - Conservative Index) on returns across all timeframes.