While we have been waxing eloquent about the benefits of portfolio diversification, it is important to acknowledge that creating an optimally diversified portfolio is no easy task. Investors are often confused about whether to invest in debt or equity. Even when they decide upon creating exposure to both asset classes, determining the mix or proportion can be challenging. In such cases, investors can consider investing in a Dynamic Asset Allocation Fund. These funds dynamically manage their exposure to equity and debt instruments in response to changing market conditions. Dynamic asset allocation funds fall under the hybrid category of mutual funds.
What are Dynamic Asset Allocation Funds?
Dynamic asset allocation funds invest in a mix of debt and equity instruments. The allocation to equities is based on pre-defined market metrics such as the PE ratio, price to book value or any other in-house developed proprietary model. When these metrics become favourable then the fund increases its exposure to equities and when they become unfavourable it decreases its exposure to equities. In this way, it dynamically manages its equity exposure to capture the benefits of equity investing.
How is a dynamic asset allocation fund different from a diversified equity fund?
As the name suggests, diversified equity funds primarily have exposure to equity instruments and are generally fully invested in order to comply with regulations. This means that they are not really in a position to take any cash calls or leverage intermittent opportunities. On the other hand, dynamic asset allocation funds can invest in a mix of debt and equity and are well positioned to increase or decrease their allocation to equities and debt in response to the changing investment environment and in an attempt to leverage intermittent opportunities. The equity component of the portfolio can go up to 100 per cent or even down to zero per cent, depending on the prevailing market scenario and the type of valuation methodology used to determine equity exposure. Generally, most fund houses maintain their equity exposure in the range of 30 per cent to 80 per cent. Fund houses have the liberty to use their own methodology for calculating their equity exposure.
Dynamic asset allocation funds not only give investors exposure to, equity and debt, asset classes but also help investors reap the benefits of equity investing by dynamically managing their exposure to the asset class. As a result, investment in such funds can also help invest mitigate portfolio volatility and smoothen long-term portfolio returns.