Why Dynamic funds should be a part of your investment portfolio?
There are many mutual fund schemes in the market ranging from equity, debt, hybrid, index, dynamic, thematic etc. Some are actively-managed funds, and some are passive.
One type of scheme that is often less explored is dynamic funds, also known as self-balancing funds. Just like balanced funds, dynamic funds also have a mixture of equity and debt, but the equity-debt mix is a lot more dynamic.
What are Dynamic/Self-Balancing Funds?
Dynamic funds switch between different asset classes like equity, debt and cash depending on the market conditions. The funds are specifically designed to switch between these asset classes depending on how attractive each asset class is.
Every conscious stock market investor knows that equities should be bought when markets are low and should be sold when markets are high. However, an investor might not be able to determine when the time is right to buy and when it is right to book profit.
Dynamic mutual funds address this specific issue by switching to different asset classes based on their attractiveness, which is determined by certain valuation metrics. The allocation between equity and debt is not decided by the fund manager but by a formula.
Some funds arrive at their own formula based on Nifty’s P/E, while some funds follow Price to Book Value. This involves a bit of automation to identify a time when the equity markets are going to fall and book profits accordingly or identify a time when equity markets are low enough to take more equity exposure.
Basically, a dynamic fund is an absolute return fund, and it generates returns by making gains in equity investments and holds on to the gains by booking profit when the markets are not doing well. Hence, these funds usually underperform as compared to pure equity funds
Why invest in dynamic funds?
The typical equity investor behaviour is to invest when markets are high and stay away when markets are down. Such behavioural bias eats into the returns that an investor would have otherwise made.
For investors who believe in investing for long-term also, a need arises to periodically rebalance their portfolios to maintain the asset allocation ratio of equity and debt. Also, some investors prefer to book profit when markets are sky high and do not want to lose the gains they have made.
But an investor has to continuously monitor the markets and spend the time to analyse if the time is right for profit-booking or for investing more into equity. If the portfolio of the investor has tilted more towards equity, he has to spend considerable time to identify the investments to book profit and the right debt investment to hold the gains.
It is suitable for people who do not want to take high risk and prefer lesser volatility in their investments. Investors can invest in these funds if they do not have time to construct and monitor a portfolio or rebalance it when required.
Differences between Hybrid and Dynamic Funds
Both Hybrid funds and Dynamic funds have an approach for asset allocation in equity and debt based on market conditions. The key difference is that the hybrid funds have to maintain a steady exposure to equity and debt. The exposure to equity and debt in hybrid funds largely depends upon the asset allocation strategy of the scheme which can be in the ratio of either 65:35, 75:25, 15:85 of equity and debt.
Dynamic funds switch aggressively between equity and debt. Their equity exposure can vary from 0-100% depending on the market conditions.
Dynamic funds are less volatile as compared to hybrid funds as they exhibit a lower standard deviation (SD). But balanced funds deliver better returns over the long-run as compared to dynamic funds.
Advantages and Disadvantages
Let us discuss the advantages of the dynamic funds first.
- Dynamic funds can give higher returns at lower risk as they have the lowest volatility.
- Dynamic funds tend to lose less during a market correction. Since the portfolio is automatically balanced during the time of a market correction, it is suitable for risk-averse investors.
- A well-managed dynamic fund can save the investors from the headache of timing the market and generate good returns if held for a long time.
Let us now discuss the disadvantages of the dynamic funds.
- Because of aggressive rebalancing, dynamic funds often cannot take advantage of the market upside effectively, to make better returns.
- Dynamic funds use complex formulae to arrive at their asset allocation ratios during every market movement using different metrics. Hence, it is difficult to benchmark and compare a fund’s performance with its peers.
- As the asset allocation is very dynamic, the transaction costs can be high and hence, the expense ratio can also be high.
- Dynamic funds are not very tax-efficient. These funds are considered as non-equity funds for tax purposes even if they have maintained an equity asset allocation of 65% or higher.
Case Study of a Dynamic Funds
- Motilal Oswal Dynamic Fund
The fund house has created their own index – MOVI (Motilal Oswal Value Index) to determine their market valuation. MOVI is calculated using 3 indicators – Price/Earnings, Price/Book Value and Dividend Yield of Nifty 50 index.
The fund aims to invest in asset classes such as equity, equity derivatives, debt, money market instruments and in REITs.
The asset allocation is done based on the MOVI only, i.e. if the MOVI is low, it indicates lower valuations and the portfolio is automatically rebalanced to increase equity allocation. If the MOVI is high, it indicates that the market is overvalued and the portfolio is rebalanced to have higher debt exposure.
Here, an investor might be aware of the 3 indicators that are being used in the MOVI index but not about the formulae used to determine the index value.
- SBI Dynamic Asset Allocation Fund
This fund aims to invest in equities, debt and cash. It makes use of a pre-determined automated model known as quantitative model/quant model to determine the asset allocation ratios at a given point in time.
Under equities, the fund will invest only in securities that are part of Sensex index and in the same proportion they constitute the index. Under debt, it will buy 10-year benchmark government security, and under cash, it will buy short-term treasury bills.
Also read: How to rebalance Mutual Fund Portfolio
The fund manager risk is minimal in this fund as the securities are chosen passively from the constituents of the index. Its equity exposure can shift from 100% to 0% depending on the prevailing market scenario.
- Franklin Templeton Dynamic PE Ratio Fund of Funds
Like other dynamic funds, the asset allocation between equity and debt in this fund can vary from 0-100%. However, the unique feature of this fund is that the underlying assets are not securities or bonds but the equity and debt funds of the fund house.
The portfolio mix of this fund is based on the Nifty PE levels at the end of each month. If the Nifty PE is at lower levels, the exposure to equity is increased to 90-100%. If the PE is at a higher level, more exposure is taken to debt. If it is in between, the asset allocation would be at the fund manager’s discretion which can be 65-35%, 30-70% etc.
Because of their flexible structure, a dynamic fund is best suited to capture market opportunities, but sometimes the aggressive rebalancing fails to capture the market upside. These funds are less volatile and can give good returns over the long term but may not match the returns of a pure equity fund.
Since there is no benchmark to compare a dynamic fund to its peers, it becomes difficult to gauge how well a fund has performed as against how well it could have performed.
However, dynamic funds are best-suited for investors who cannot time the market or cannot stomach the losses during a market turn down or can’t stop from getting carried away during an upward movement of the market.