Why Dynamic Asset Allocation Funds Make Sense

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

The Indian equity markets have been riding a liquidity-driven wave since the RBI opened the tap in 2020 to save the economy from COVID 19! Buoyed by household savings that are flowing into stocks – some directly, and some through the mutual fund route, stocks have done very well indeed after recovering from the shock of two years ago.

With the Russia-Ukraine standoff sending crude prices rocketing past USD 115, the economic fallout for India, a net importer of oil, is inevitable. It’s a matter of time before a high inflation drives down easy the easy liquidity that we’ve seen in the past 2 years. The question is, what then?

Although the froth has been shaved off to a large extend and valuations are nowhere as rich as they were a year back, geopolitical risks threaten to upset the apple cart. What will Putin’s end game be, and how far will this go, is the question the world – and stock markets – are asking right now. We’ll know when we know! But until then, how will markets behave? Will they head south or “brush off” concerns and continue their skyward trajectory? It’s impossible to predict.

Another possibility exists – that of further mean reversion. With a lot of the expected EPS growth priced in and a distinct “risk-off” mood building up, markets have been reverting to their long-term averages in terms of valuations and will continue doing so. 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 keeps repeating itself, and probably will until time immemorial.

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 per cent, to ensure that their tax efficiency is at par with pure equity 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 as well as technical indicators. 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 volatile 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 moneys 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 per cent to +60 per cent in the past! So do make sure you invest into DAA funds with a minimum time horizon of three years.