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Why Dynamic Asset Allocation Funds Make Sense Right Now

DAA funds are a "shut and forget" type of moderate risk fund that will never provide blockbuster returns; but will eventually earn you a tax efficient, rational, risk adjusted return

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What should your percentage allocation to equity oriented mutual funds be right now? 80%? 20%? 40%? 100%? There's no simple answer.

The Indian equity markets have been riding a liquidity-driven wave for quite some time now. Buoyed by household savings that are flowing into stocks - some directly, and some through the mutual fund route - the broad indices have managed to hold their own, even amidst an extended paucity of earnings growth.

That valuations are rich is undeniable. The P/E Ratio of the bellwether NIFTY index now oscillates between 25 and 26 times current earnings; a number perilously close to its 2008 peak. And as is always the case, we're seeing retail moneys chasing past returns - an estimated 20,362 Crores flowed into equity/ equity oriented mutual funds in August alone. Is this wise? Probably not.

Stock markets possess the intrinsic ability to stay in overvalued or undervalued territory for extended, and unpredictable periods of time. John Maynard Keynes rightfully observed that "markets can remain irrational longer than you can remain solvent"

Another inevitability exists - that of mean reversion. In the absence of fundamental factors either fueling or curtailing corporate earnings growth, markets will eventually tend to revert to their long-term averages in terms of valuations. This famed syndrome of mean reversion has caught many a retail investor off-guard over the decades. Having invested into the "best performing" equity funds in a blaze of euphoria, they find themselves sitting on heavy losses after markets correct back to more rational valuations. Since Financial Markets have short memories, history notoriously repeats itself!

Whether or not markets will correct slightly, sharply, or not at all in the immediate future is unpredictable. Whether the mirage of earnings growth will vanish and give way to real numbers is, too. In such push and pull scenarios, an elegant solution exists in the form of Dynamic Asset Allocation (DAA) Funds.

Put simply, DAA funds are a "shut and forget" type of moderate risk fund that will never provide blockbuster returns; but will eventually earn you a tax efficient, rational, risk adjusted return. As the name suggests, DAA funds dynamically rebalance their allocations between equity and debt assets, while using hedging strategies to keep the overall "equity allocation" in excess of 65%, so that dividends and long-term capital gains arising from them are deemed tax-free.

Popular Dynamic Asset Allocation Mutual Funds

The model followed to arrive at the optimal split between high risk and low risk assets varies across fund houses. Some use the trusty old P/E ratio, some use variations of the P/B ratio, and still others employ proprietary indices. However, one thing remains common to these funds - as markets move up and valuations rise, their percentage allocation to stocks is systematically reduced, and vice versa. If most investors were to examine their past investing patterns, they'd likely find that they did the opposite - and paid a heavy price on more than one occasion!

In market conditions such as the present one, investors are at an elevated risk of taking repeat irrational decisions based on greed and fear, leading to losses and regrets in the medium term. Given that, fence sitters and seasoned mutual fund investors alike would be making a wise move by allocating at least half their portfolios to DAA funds right now. However - do so with the clear understanding that these funds are not by any means, low risk in nature. No DAA strategy will help safeguard your capital - in fact, worst year and best year returns from popular DAA funds have ranged from -40% to +60% in the past! Make sure you invest into DAA funds with a minimum time horizon of three years.

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