While long-term returns of these funds may be subdued compared to diversified equity MFs, they are less volatile
Kayezad E. Adajania | Last Modified: Thu, Oct 15 2015. 08 19 PM IST | LiveMint
How do you make money in a market that goes up, say, 9% (2013) one year, then shoots up 30% (2014) in the next, and then comes crashing down the following year (by 2.42% so far this year)? The tried and tested way is to allocate assets properly; and invest in equities and debt as per your risk profile and market movements. But that’s easier said than done, isn’t it?
Let’s see how balanced funds—these invest across equities and debt—have performed. Between February 2014 and January 2015, the category returned 42% on an average. But since February 2015 till date, the category lost 1.12%.
But there’s another animal that does asset allocation more efficiently than balanced funds. They’re called dynamic asset allocation (AA) funds. As against balanced funds, which maintain a steady balance of equity and debt split, or even diversified equity funds, which always remain invested in equities, dynamic AA funds switch between equities and debt completely; they can invest zero to 100% in equities, depending on how markets behave. But does such dynamism help?
Although all dynamic AA funds switch between equity and debt, not all behave the same way. Funds such as Franklin India Dynamic PE Ratio Fund of Funds (FDPE) and Principal Smart Equity Fund (PSEF) switch based on the price-equity ratio (P-E) of the CNX Nifty index. A P-E ratio, to put it simply, indicates if equity markets are overvalued or undervalued. Higher the P-E, more the markets are considered overvalued; and lower will be these funds’ equity allocation.
DSP BlackRock Dynamic Asset Allocation Fund (DBDA) looks at the yield gap formula. It is calculated by dividing the 10-year government security’s yield by earnings yield of Nifty. The numerator is a proxy for debt markets, and the denominator is a proxy for equity markets. So, the ratio looks at how cheap or expensive equities are when compared to debt markets. If the number is high, it means expected returns from equities are low, and so a higher allocation to debt is necessary.
While PSEF invests directly in equities and debt, funds such as FDPE and Kotak Asset Allocator Fund (KAAF) are fund of funds (FoFs); they invest in other MF schemes. All these FoFs invest in in-house schemes. In cases like FDPE, the schemes are sacrosanct. But schemes like KAAF have earmarked multiple schemes for their debt and equity allocation. “Once the quant model decides the equity-debt split, the fund management team decides which funds (large-cap, mid-cap and so on) the FoF will invest in,” said Lakshmi Iyer, chief investment officer (debt), Kotak Mahindra Asset Management Co. Ltd.
Have they delivered?
Of all the dynamic AA funds, only three have been around for a significant period of time— FDPE, launched in October 2003; PSEF and DHFL Pramerica Dynamic Asset Allocator Fund (DPDA), both launched in December 2010. In rising markets between February 2014 and January 2015, FDPE and DPDA returned 33.27% and 26.68%, respectively, finishing in the bottom quintile of the moderate allocation category, as per data provided by Morningstar, a global MF research firm and data tracker. Morningstar classifies all schemes where equity allocation is between 30% and 75% in this category.
Fortunes changed in 2015, when markets started to fall. KAAF (3.51%), DBDA (2.06%) and FDPE (1.30%) finished in the top quintile between February 2015 and 12 October 2015. But on an average, the category lost 1.12% in the same period.
“There is a myth that people come to mutual funds for high returns. If that were the case, then so much money wouldn’t be invested in fixed deposits. Investors want a good experience. Returns are important, but if a fund is able to give a solution, like rebalancing, and return decent money over long periods of time, investors are happy,” said Kanak Jain, mentor, Ask Circle Mutual Fund Round Table India, one of the country’s largest MF distributor association.
Most of the funds are new in this space so we don’t have long-term data on whether these models have worked or not.
For instance, DBDA, which uses the yield-gap model, was launched only in February 2014. The good news is that months after its equity allocation being static at about 12% since launch, it moved up to 29% in August earlier this year when markets sank sharply, and to about 38% in September, when the Reserve Bank of India cut interest rates.
“The formula did exactly what it was supposed to do, and at the right time,” said Ajit Menon, head-sales and co-head-marketing, DSP BlackRock Investment Managers Pvt. Ltd. Menon admitted it was unnerving that the formula didn’t budge all of last year and most part of this year as well. “But last year, the equity rally was a ‘hope’ rally; there wasn’t much change on the ground,” he said.
While long-term returns may be subdued as compared to that of diversified equity funds, these funds are less volatile. We looked at standard deviation, a measure of a fund’s volatility.
According to Morningstar, average standard deviation of moderate allocation, flexi-cap and large-cap funds together was 11.94, while that of all dynamic AA funds was between 1.95 and 7.19; which is among the lowest.
“The risk-return combinations are important. These funds help significantly reduce volatility in your portfolio,” said Janakiraman R., portfolio manager-Franklin Equity, Franklin Templeton Investments–India.
Mind the tax gap
One drawback that dynamic AA funds have is in terms of taxation. On account of being FoFs, they are classified as debt funds and taxed accordingly, even if they are equity-oriented.
If you sell your debt funds within three years, you pay taxes as per your income tax rates on your gains. The threshold to claim tax benefit on long-term capital gains is three years, and even then, long-term capital gains tax is 20% (with indexation benefits).
That’s one reason why KAAF changed its objective, in October 2014, from being just an equity FoF to one that dynamically allocates its money to debt and equity, based on a certain formula.
“Earlier, all our investments were going in equity funds and yet KAAF was considered a debt fund. A dynamic asset allocation model, therefore, is superior,” said Iyer, adding that an “unfavourable tax structure” has been one of the biggest impediments to this product becoming popular with investors.
Should you invest?
Not all financial planners recommend dynamic AA funds because they feel it is their prerogative to do their client’s asset allocation. But quite a few planners have warmed up to such funds.
Yogin Sabnis, managing director, VSK Financial Consultancy Services Ltd, is a fee-based planner who still manages a motley group of investors from his early days when he didn’t charge fees. Such investors, he explains, either don’t require much financial planning or hesitate to shift to paying fees. Such clients, he said, are advised to invest in dynamic AA funds. “I don’t recommend this product to my fee-based clients because I do their asset allocation. But if someone wants a one-off advice, this is one of the first recommendations because with these funds, even if the customer doesn’t consult an adviser, the fund automatically does the rebalancing,” said Sabnis.
Jain, who has systematic investment plans going on in some of these funds on behalf of two children, feels advisers and distributors should focus more on the long-term goals of clients and their servicing, and leave rebalancing to such funds. Added Janakiraman, “Usually, we do asset allocation only in extreme situations. We don’t do it all the time, which we are supposed to. These funds monitor asset allocation at all times.”
The category does not have many schemes. And the ones that are there, don’t have long-term track records. But the ones that come with a track record have largely worked so far. The yield gap model, for instance, shows promise though DBDA lacks a long-term track record.
It’s best to stick to larger fund houses and also with those that are FoFs, despite their inherent tax disadvantage. If the underlying funds come with a good track record, then the only thing you need to watch out for is the asset allocation model.
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