Dynamic asset allocation fund gives the best of debt and equity

Debt mutual funds have lost their tax and indexation benefits. To counter this,  fund houses are changing their strategy. They are offering more dynamic asset allocation funds now. Dynamic asset allocation fund has the option to change its allocation to increase proportion of equity and save investors from loss.

So what is dynamic asset fund and how does it work. Dynamic Asset Allocation Fund is also called a Balanced Advantage Fund. It is a hybrid mutual fund that invests in both equity and debt instruments. According to the Association of Mutual Funds in India (AMFI), the fund manager of balanced advantage fund has to manage this investment in equities and debt in a very dynamic way. Investment in equity and equity-related instruments can range from 0% to 100%, and rest will go in debt.

Investment flexibility

Keep in mind that fund houses have the flexibility to invest anywhere between 0% to 100% in equity or debt, depending on market conditions. However, most balanced advantage funds generally have an equity allocation of 65% to 100%. Fund managers have to keep a close eye on the fund and make changes between equity and debt investments based on market research and analysis, in line with the investment objectives of the scheme. When stock valuations become attractive, the equity exposure is increased in these schemes, and when valuations become expensive, the equity exposure is reduced.

For example, in March 2023, several balanced advantage funds increased their allocation to stocks.

Dynamic asset allocation fund managers allocate assets based on various models. Some funds invest based on the price to earnings (PE) ratio, while others use price to book (PB) value. Many funds create their own model and follow it. For example, the Quant Mutual Fund uses the valuation, liquidity, risk and timing (VLRT) framework for the money management of its Quant Dynamic Asset Allocation Fund. VLRT has four elements: Valuation Analytics, Liquidity Analytics, Risk Appetite Analytics, and Timing. Based on the chosen model and the condition of the stock market, fund managers adjust the equity or debt allocation. Dynamic asset allocation helps in reducing risk.

As per Value Research data, dynamic asset allocation funds have give 1.6% return in 1 year, 17% in 3 years, 7% in 5 years and 11% in 10 years.

Tax rules

Talking about taxation, mutual funds are divided into equity-oriented or non-equity oriented funds for taxation purpose. If at least 65% of the investment in a dynamic asset allocation fund is in equity, it will be an equity-oriented fund. Such funds will levy capital gains tax of 10% on investments held for more than a year and in investment is held for less than a year, capital gains tax of 15% is levied. In addition, long-term capital gains of less than Rs. 1 lakh are tax-free. For non-equity oriented funds, if the holding period is less than three years, it will be considered as short-term capital gains, and will be taxed as per income slab.

If the holding period is more than three years, it will be considered as long-term capital gains, and a tax of 20% will be imposed on it. It will also benefit from indexation.

In other words, before investing in DAAF, you need to keep in mind asset allocation ratio in the fund, only then will you be able to get an idea about how tax will be imposed in the scheme.

Now the question is what type of investors should invest in this fund. Experts say that this is good for investors who want higher returns having medium risk appetite. The fund’s dynamic asset allocation approach reduces the impact of market volatility, and investors receive risk-adjusted returns.

Arbitrage benefit

Even when the market falls, these funds decline less compared to pure equity funds, because of their exposure to derivatives and arbitrage. The benefit of this is that the investor’s capital remains relatively secure while also receiving good returns. After changes in tax rules for debt funds, many funds have started changing their investment strategies. For example, when the Quant Dynamic Asset Allocation Fund was launched, it was said to be similar to a debt tax saving fund. However, after changes in tax rules for debt funds, Quant Mutual Fund announced that it would change its investment strategy and make it an equity fund.

Investing in a dynamic asset allocation fund can be a great way to add diversity to your portfolio. These funds offer more favourable risk-reward ratios. Meaning, you get higher returns than debt funds. However, as per experts you should invest in a dynamic asset allocation fund for at least three years for good returns. This is because long-term investments are less affected by market fluctuations. It’s important to note that these funds invest in equity, so you need to have a moderate risk appetite. Additionally, it’s worth noting that fund houses are increasing their equity allocations to save taxes, but this also increases the fund’s risk.