For new, risk-averse equity investors

Investors willing to accept underperformance from diversified equity funds in bull markets may invest in dynamic asset allocation funds for their lower volatility

When the equity markets enter the high valuation zone, as is the case now with the Nifty trading at a trailing price-to-earnings (P/E) ratio of around 23, future returns from equities tend to be low. At such times, investors would do well to direct less of their fresh investments into equities and more into debt. One class of mutual funds that can help them do so is dynamic asset allocation funds.

Different funds use varied criteria, such as P/E and price-to-book value, to determine their equity allocation. They usually have pre-determined bands to decide equity allocation. Fund houses like ICICI Prudential, Franklin, DSP BlackRock, Principal, HSBC, etc offer these funds.

Their primary advantage is that they take away human biases. "Investors enter the equity markets when they are rallying and avoid them during bear phases, when they are attractively valued. These funds invest more in equities when they are cheap and book profits when markets are up," says Rajat Jain, chief investment officer (CIO), Principal Mutual Fund. By making asset allocation rule-based, they also take away discretion from the fund manager, who could be equally prone to biases.

Retail investors may not rebalance their portfolios. By outsourcing this responsibility, they can ensure that it gets done consistently. Rebalancing is also more tax-efficient when done by a fund. "When an investor sells equities, he could incur potential capital gains tax while a fund does not," says Jain.

One drawback of these funds is that they can underperform the markets during bull runs. "While dynamic asset allocation funds may limit the downside in a declining market, such funds may underperform pure equity funds in a long bull cycle," says Manish Gunwani, CIO-equity, ICICI Prudential AMC. A fund's rules could say that it will sell 20 per cent of its equity holdings when the market PE goes beyond, say, 18, and more as it climbs further. The market could stay in the above-18 zone for as long as two-three years. It could be a long time before the market PE returns to a level when the fund can buy equities again. "The fund could underperform in such periods because it reduced exposure to equities when the rally was in its infancy," says Arnav Pandya, a Mumbai-based financial planner.

As for the benefit of regular rebalancing, Vidya Bala, head of research, Fundsindia.com, says: "Do your asset allocation through separate equity and debt funds. An annual rebalancing should suffice for most retail investors." As an investor's portfolio grows, he may find it difficult to maintain the right asset allocation if rebalancing is done both by him and the fund.

Dynamic asset allocation funds are suited for investors who have entered the markets recently, have a small corpus, want equity exposure, and can't handle rebalancing themselves. They also suit those who don't mind some underperformance vis-a-vis equity funds so long as they get a less volatile ride. Investors must hold these funds over an entire market cycle. "Look at the pedigree of the fund house and for long-term track record of performance when choosing a fund," says Gunwani.

The tax treatment of these funds will depend on their average equity exposure during the year, which must stay at 65 per cent or above for them to get equity-like treatment. When markets turn expensive and they reduce equity exposure, some of them add an arbitrage component to maintain this tax treatment. Those having the fund-of-funds structure will be treated at par with debt funds.
PROS AND CONS OF THESE FUNDS

• These funds invest less in equities when the markets are up, more when they are down
   
• Fund managers and investors in them don't fall prey to human biases
  

 

Rebalancing happens regularly, without the investor incurring capital gains tax
 

Can underperform during sharp, uni-directional market rallies