Why Dynamic Asset Allocation Funds Make Sense

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What should your percentage allocation to equity-focused mutual funds be right now? 80 percent? 20%? 40%? 100 per cent? There is no simple answer.

Indian stock markets have been riding a wave of liquidity since the RBI turned on the tap in 2020 to save the economy from COVID 19! Supported by household savings flowing into equities – some directly, and some through mutual funds, equities have indeed performed very well after recovering from the shock of two years.

With the standoff between Russia and Ukraine pushing crude prices past $115, the economic fallout for India, a net oil importer, is inevitable. It’s only a matter of time before high inflation easily brings down the easy liquidity we’ve seen over the past 2 years. The question is, what then?

Although the scum has largely been shaved off and valuations are nowhere as rich as they were a year ago, geopolitical risks threaten to upend the apple basket. What will Putin’s endgame be, and how far will it go, is the question the world – and the stock markets – are asking right now. We will know when we know! But until then, how will the markets behave? Will they head south or “sweep away” the concerns and continue on their upward trajectory? It is impossible to predict.

Another possibility exists, that of another reversion to the mean. With much of the expected EPS growth and a distinct “risk” mood developing, markets have returned to their long-term averages in terms of valuations and will continue to do so. This famous mean-reversion syndrome has caught many retail investors off guard over the decades. After investing in the “best performing” equity funds in a blaze of euphoria, they find themselves sitting on heavy losses after markets return to more rational valuations. Since financial markets have a short memory, history keeps repeating itself, and probably until time immemorial.

Whether markets correct slightly, sharply or not at all in the immediate future is unpredictable. Whether the mirage of earnings growth will fade and give way to real numbers is also a question. In such push and pull scenarios, an elegant solution exists in the form of dynamic asset allocation (DAA) funds.

Simply put, DAA funds are a “closed and forgotten” type of moderate risk fund that will never provide exceptional returns; but will ultimately earn you a tax-efficient, efficient and risk-adjusted return. As their name suggests, DAA funds dynamically rebalance their allocations between equities and debt securities, while using hedging strategies to keep the overall “equity allocation” above 65%, to ensure that their tax efficiency is on par with pure equity funds.

The model followed to arrive at the optimal allocation between high-risk and low-risk assets varies from one fund house to another. Some use the old faithful P/E ratio, some use variations of the P/B ratio, and still others use proprietary indices as well as technical indicators. However, one thing remains common to these funds: as markets rise and valuations increase, their percentage allocation to equities is systematically reduced, and vice versa. If most investors were to examine their past investing habits, they would likely find that they have done the opposite – and paid a heavy price on more than one occasion!

In volatile market conditions such as the current situation, investors run a high risk of making repeated irrational decisions based on greed and fear, leading to medium-term losses and regrets. Given this, fence keepers and seasoned mutual fund investors would make a wise decision to allocate funds to DAA funds now. However, do so with the clear understanding that these funds are by no means low risk in nature. No DAA strategy will help you protect your capital – in fact, the worst and best year returns of popular DAA funds have ranged from -40% to +60% in the past! So be sure to invest in DAA funds with a minimum time horizon of three years.


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