Dynamic Asset Allocation in Mutual Funds
Mutual funds pool together the capital from various investors and invest the money in a basket of assets. Asset allocation is the manner in which the common capital is distributed across different assets and asset classes. There are different strategies to help determine the asset allocation in mutual funds. Some mutual funds may adopt a more passive approach with a fixed asset allocation, while others may take a more active approach with dynamic asset allocation.
In the dynamic asset allocation strategy, there is no fixed asset mix required for the fund. Instead, fund managers actively modify the asset allocation based on market movements and broad economic indicators. This leads us to dynamic asset allocation funds, which are quite popular in today’s mutual fund industry.
Read this article for in-depth insights into dynamic asset allocation funds, how they work and what their pros and cons are.
What is a Dynamic Asset Allocation Fund or a Balanced Advantage Fund?
A dynamic asset allocation fund is a type of mutual fund that invests in a wide range of assets and asset classes. They may include equity stocks, equity funds, bonds and other debt instruments, real estate and more. The proportion in which the common capital is distributed across these assets is flexible and dynamic.
Since there is no fixed asset ratio to target, fund managers in charge of dynamic asset allocation funds are free to redeem certain investments and/or enter into new positions. Typically, exposure in the worst-performing assets is reduced, while positions in the better-performing assets are increased.
Since these funds are balanced regularly to offer a consistent advantage to investors based on prevailing market conditions, they are also known as balanced advantage funds.
Dynamic Asset Allocation: An Example
Say you have invested in a balanced advantage fund that follows the dynamic asset allocation strategy. Now, suppose the stock market records bullish trends for six months continuously, the fund manager may increase the exposure in the equity segment and redeem some fixed-income assets instead.
However, a few months later, let’s assume that a geopolitical event starts to impact the global equity market adversely. If there is no positive upturn for a few weeks, the fund manager may steadily divest from equities and increase allocation in the debt market instead.
Advantages of Dynamic Asset Allocation
The dynamic asset allocation strategy used in balanced advantage funds has several advantages, as outlined below.
Adaptability to Market Conditions
One of the most significant benefits of dynamic asset allocation is its adaptability to changing market conditions. It allows investors to capitalise on prevailing trends and avoid potential downturns, thereby optimising returns.
Dynamic asset allocation provides a mechanism to adjust exposure to different asset classes based on the current risk profile. This can protect the portfolio from unforeseen market shocks or volatility.
Potential for Higher Risk-Adjusted Returns
By actively adjusting the portfolio in response to market conditions, there is a possibility of achieving higher returns compared to a static asset allocation strategy.
Even though the strategy changes asset allocations frequently, it generally results in a well-diversified portfolio across different asset classes. This can reduce the risk of significant losses in many cases.
Tailored Investment Strategy
Dynamic asset allocation is not a one-size-fits-all approach. It can be customised based on individual risk tolerance, investment horizon and financial goals.
Instead of reacting to market downturns after they occur, dynamic asset allocation takes a more proactive approach and aims to predict and prepare for market changes.
Limitations of Dynamic Asset Allocation
While dynamic asset allocation can be a flexible and potentially rewarding investment strategy, it’s essential to weigh its advantages against its limitations and determine if it aligns with your investment goals and risk tolerance. So, you need to be aware of the following risks or downsides:
Dynamic asset allocation often involves more frequent trading and hands-on management of the funds. This can, in turn, lead to increased investment costs for investors.
Risk of Misjudgment
Predicting market movements can be challenging. There’s always the risk that the chosen asset allocation might not align with future market performance.
Over-Reliance on Past Data
Many dynamic strategies rely heavily on past market data to make future predictions. However, past performance is not always indicative of future results.
Potential for Emotional Decision-Making
Due to the active nature of the strategy, there’s a risk that emotional biases can influence decisions, especially during periods of high market volatility.
Potential for Underperformance
While the goal is to outperform a static asset allocation strategy or a benchmark, there’s no guarantee that the dynamic approach will always succeed. In some years, the strategy might underperform due to misjudgments or unexpected market shifts.
Are Dynamic Asset Allocation Funds Suitable for You?
To decide if dynamic asset allocation funds are right for you, you need to consider various factors as outlined below:
If your goal is to earn potentially higher returns by capitalising on market trends and conditions, dynamic asset allocation funds might align with your objectives. However, it’s crucial to remember that these funds are not immune to market downturns. Their primary aim is to minimise risks and optimise returns rather than guarantee them.
Dynamic asset allocation funds aim to adjust to market conditions, potentially reducing risk exposure during downturns and increasing exposure during uptrends. If you are comfortable with a strategy that continuously changes the asset allocation in response to market predictions, this might be a good fit.
These funds are typically best suited for investors with long-term investment horizons. That said, the active adjustments made by the fund managers might cushion short-term volatility, making it potentially suitable for medium-term investors too.
Active vs. Passive Preference
If you prefer a more passive investment approach, a static allocation strategy or an index fund might be more in line with your preferences. However, if you believe in the potential benefits of active management, dynamic asset allocation could be an attractive choice.
Since they are actively managed, dynamic asset allocation funds can have higher expense ratios than passive funds. If minimising costs is a top priority for you, you need to compare the projected returns against the fund’s expenses to see if it’s a good fit for your portfolio.
With this, you should get a better idea of what balanced advantage funds or dynamic asset allocation funds are, how they work and the risks and benefits associated with them. You can now make a more informed decision about including these funds in your portfolio. If you decide to invest in a dynamic asset allocation fund, ensure that you perform adequate research about the expertise of the fund manager and the terms and conditions associated with the fund before you proceed.
Is a dynamic asset allocation fund the same as a balanced advantage fund?
Yes, a dynamic asset allocation fund is the same as a balanced advantage fund. The two terms are used interchangeably to refer to a mutual fund that invests in equity and debt assets with flexible asset allocation.
What is the difference between a balanced fund and a balanced advantage fund?
A balanced mutual fund invests in both debt and equity almost in equal proportions. However, a balanced advantage fund has more flexible asset allocation criteria across different asset classes.
Do dynamic asset allocation funds guarantee higher returns?
Dynamic asset allocation funds do not offer any kind of guarantee on the returns since they are market-linked assets. The main goal of these funds is to manage risk, which could lead to better risk-adjusted returns.
How frequently do these funds change their asset allocation?
The frequency of changing the asset allocation varies based on market conditions and the strategy of the dynamic asset allocation fund. Some funds may review their portfolios monthly, while others could make changes more sporadically.
Can I withdraw my investment from a dynamic asset allocation fund at any time?
If the dynamic asset allocation fund is an open-ended mutual fund, you can redeem your units at any time. However, some funds might have an exit load if you withdraw before a specific period.