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What are dynamic asset allocation funds? Detailed guideline & analysis of investing in dynamic asset allocation funds in India

Dynamic Asset Allocation Funds

What are Dynamic Asset Allocation Funds?

Dynamic Asset Allocation funds are hybrid funds that invest in a mix of asset classes. They usually invest in Equity, Debt, Equity Derivatives, Real Estate, etc. and are managed dynamically. Based on the investment objective of the fund, the fund manager determines the asset allocation for the fund. He actively monitors the investments and rebalances the portfolio based on the market conditions to keep it in line with the investment objective. Generally, when the valuations are low, the fund increases its equity exposure, and when valuations are high, lowers the equity exposure. The fund rebalancing is backed by proper research and quantitative analysis and is not subject to emotional bias.

DAA funds invest in a way that minimizes risk based on market trends, and are targeted  at first time and low-risk appetite investors. DAA doesn’t involve having a target investment mix of assets. Therefore, the fund manager has a high degree of flexibility while rebalancing. The success of DAA funds depends not just on  market conditions but also on the manager’s decision-making ability. 

Who should invest

As Dynamic Asset Allocation funds invest in more than one asset class, they are designed for risk-averse investors. Long term investors who understand the risk-return trade off   and want a way to balance the Equity-Debt exposure in their portfolio might consider these investment options. As the fund manager himself will take care of the asset allocation during volatility, the investor need not worry about their investment. 

Though equity investments are risky, they beat inflation in the long term, and debt investments earn guaranteed returns. DAA funds fill the gap and offer investors a solution that is designed to balance risk with good growth over the long term. 

Importance of Dynamic Asset Allocation  

  • Diversification: ‘Don’t put all your eggs in one basket’.  As an investor never invest all your money in just one asset. Diversification is the key to better returns. DAA funds do just that. For investors who would like to diversify investments can invest in these. These are best suited for long-term and low-risk appetite investors as they have enough exposure to equity and debt. 
  • Better Returns: As DAA funds invest across different asset classes, market fluctuations don’t have a drastic impact on their returns. Hence these funds are considered to offer better returns over more risky investments. 
  • Volatility: An up or a downtrend of any asset class cannot sustain for  long. A downtrend follows every uptrend and vice versa. DAA funds are not too volatile as they invest in multiple asset classes. Though DAA funds don’t offer returns as high as that of a pure equity fund, their fall isn’t as drastic as an equity fund, because of their genuine diversification which minimizes the impact of volatility.

Challenges of Dynamic Asset Allocation Mutual Funds

Tax Structure:

Each asset class has its tax structure. Equity taxation varies from that of debt. Within debt, Bonds, FDs, and debt MFs are taxed differently. Therefore, balancing taxation becomes a challenge while building a portfolio.

Cost:

Frequent rebalancing can be a costly affair with high transaction costs. Acquisition cost of a few assets isn’t cheap either. Frequent buying and selling will have an impact on overall returns. 

Active Management:

Dynamic Asset Allocation demands active management of the portfolio and rebalancing. It requires the fund manager to do extensive research and strategize his buying and selling. Therefore, the fund manager needs to dedicate a considerable amount of time to the fund‘s active management. 

Dynamic asset allocation fund taxation:

Dynamic Asset Allocation Funds are managed like equity mutual funds. The equity plus arbitrage is maintained around 65% or more, to be treated as an equity mutual fund for tax purposes. In instances where the assets under equity fall below 65%, the fund is managed like a debt mutual fund. Ergo, the tax for such funds depends on the allocation to equity assets in the fund.

For an equity fund, the STCG of 15% is levied in the short-term. Short-term is if the investments are redeemed before completion of one year from the date of investment. In the long term, the LTCG of 10% is applicable for gains above 1,00,000 INR. For a debt fund, the STCG tax is similar to the tax slab the investor falls in. LTCG is taxed at 20% (with indexation) if the investments are redeemed after three years from the date of investment.

Expenses

The transaction costs in dynamic asset allocation funds are high when compared to a constant portfolio fund. With continuous rebalancing of the portfolio, the costs tend to be on the higher side. The expense ratio is calculated as a percentage of the NAV. Hence the gains tend to be lower in this case. 

The expense ratio charged by the fund houses is less when compared to a DIY (Do Your Own) portfolio using the dynamic asset allocation strategy. The costs involved in continuous rebalancing plus the taxation will leave nothing for the investor. Hence, it is always optimal to choose a mutual fund over a DIY portfolio in this case.

Dynamic Asset Allocation Funds in India

Indian markets can be quite volatile. Any national and international news causes considerable volatility in the market. Be it political unrest in the country or Brexit or USA China tariff wars; everything affects the Indian market. 

Dynamic asset allocation strategy best suits markets that are highly volatile. It is practically impossible to time a volatile market. Investing in pure equity or debt can be challenging. This strategy strikes a balance between risk and returns with lower drawdown than a pure equity investment and higher return than a pure debt investment.

Published on February 10, 2020