What are Dynamic Asset Allocation Funds

Dynamic asset allocation funds or Balanced Advantage Funds are a type of hybrid mutual funds. Hybrid mutual funds invest in multiple asset classes e.g. equity, fixed income etc. These schemes work on the principle of asset allocation, a strategy to balance risk and returns by investing in different asset classes.

Types of asset allocation strategies

• Strategic asset allocation: These funds have a static asset allocation mix. Hybrid schemes which follow this strategy usually have the flexibility of managing their asset allocation within ranges specified in the Scheme Information Document (SID) e.g. equity 65 – 80%, fixed income 20 – 35% etc, but the ranges are not very wide and the fund managers stick to the asset allocation ranges irrespective of market conditions.


• Tactical asset allocation: Tactical asset allocation is a variant of strategic asset allocation strategy wherein the investor can occasionally deviate from the long term strategic asset allocation to take advantage of market opportunities. Tactical asset allocation involves market timing and requires considerable investment expertise.


• Dynamic asset allocation: In this asset allocation strategy, you continuously adjust your asset allocation mix depending on market conditions i.e. you will increase or decrease your allocations to equity and fixed income on an ongoing basis depending on market movements using some investment rules / models which have been back-tested to check their efficacy in different market conditions.

Dynamic asset allocation versus strategic asset allocation

Pros

• Dynamic asset allocation has lower volatility and limited downside risks


• They can give superior risk adjusted returns


• Advantage of systematic process driven approach versus discretionary decisions based on gut feelings

Con

• Strategic asset allocation with high equity allocation tend to produce higher returns compared to dynamic asset allocation in bull markets

Asset allocation in Dynamic Asset Allocation Funds

• Net or Active Equity: This is the un-hedged equity exposure of the fund. Net equity allocation is determined by a quantitative dynamic asset allocation model based on market conditions.


• Fixed Income: Fixed income allocation is determined by the asset allocation model but is usually capped at 35% to ensure equity taxation.


• Arbitrage: This is the fully hedged equity component which is not exposed to market risks but generates arbitrage (risk-free) profits based on price differences in cash and futures market or corporate actions. The arbitrage component reduces the net equity exposure and at the same time, helps to keep the gross equity exposure above 65%, which enables equity taxation.

Types of dynamic asset allocation models

There are broadly two kinds of dynamic asset allocation models– counter-cyclical and pro-cyclical.

• Counter-cyclical dynamic asset allocation: Counter-cyclical models increase equity allocation (reduce debt allocation) when equity valuations decline (become cheaper) and reduce equity allocations when valuations increase. It essentially follows the investment tenet of buying low and selling high. Different fund managers use different valuation metrics for dynamic asset allocation, the most common being P/E and P/B ratios. Some fund managers use multi-factor models which combine 2 or more factors e.g. P/E, P/B and Dividend Yield etc.


• Pro-cyclical dynamic asset allocation: Pro-cyclical models aim to capture the upside during the bull market and protect downside in bear markets. Funds employing pro-cyclical models increase their equity allocation in rising markets and reduce it in falling markets. Pro-cyclical models are based on market trend indicator (Daily Moving Averages) and indicators of the trend strength / health (Standard Deviation, Downside Deviation etc). Some pro-cyclical models may use other factors like market valuations and macro-economic factors.

Which model is better?

There are merits and demerits of both. Counter-cyclical model is intuitive and simpler to understand. Pro-cyclical models on the other hand, will appeal more to experienced investors because momentum investing works in India - momentum (upward or downward) takes stock prices higher or lower irrespective of valuations. Counter-cyclical models can be less volatile in short / shallow corrections. However in long / deep corrections (e.g. 2008, 2011 and 2020) pro-cyclical models have lesser draw downs than counter-cyclical models. Counter-cyclical models tend to outperform in recoveries from market bottoms, while pro-cyclical models outperform in strong bull markets.

Conclusion

• Asset allocation helps investors balance risk and returns. It reduces volatility and produces optimal returns to meet your goals


• Dynamic asset allocation funds remove human judgement out of investment decisions and base investments on analytical factors


• You should try to understand what model a dynamic asset allocation fund is using and make informed investment decision according to your risk appetite and investment needs. You should consult with your financial advisor, if required.

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