Dynamic Asset allocation in Mutual funds – Investment for all

Those who are following this blog for a while now and understand the importance of a process in investments, surely appreciate the Asset Allocation structure in Portfolio.

I am of the firm belief that when it’s a question of investment, mutual fund is a best vehicle. Through Mutual funds you can allocate your investments in all asset classes. Besides having a regulated structure and professional management, it is a cost effective tool too.

Now when you are investing through mutual funds you have 3 ways to allocate your investments.

1. By Buying plain vanilla equity, debt, gold funds and allocate as per your risk tolerance level and goals targeted. (Followed/ advised by Most of financial planners)
2. You can invest in a pre-specified Asset allocation through specific Hybrid funds, designed for this purpose only. These funds demarcate the portfolios as Aggressive/Conservative/Moderate. Franklin Templeton, Birla sun life, IDFC, ICICI Prudential has these kinds of funds.
3. Or the Third option is to invest in Dynamic Asset allocation funds, which are also hybrid category funds, but with different investment strategy. These funds take market valuation into account to allocate among equity and debt.

In the funds mentioned in point number 2 above or In Hybrid funds in general, most of the time allocation depends on the investment strategy adopted by the scheme based on the view point of the fund manager. This human intervention sometimes creates biasness in the process and there are chances of fund manager making mistake of over allocating or allocating at the wrong time or on higher valuation in particular asset. It all depends on the experience and conviction of the fund manager.

To answer that anomaly, fund houses are coming up with a concept which allocates investments in equity and debt looking at the price earnings ratio multiple of the market and call these funds as Dynamic asset allocation funds. Recently there’s been 3-4 NFO launched based on this concept.

The basic premises of such funds are to the increase equity allocation when markets are looking cheap and reduce when market valuations are high, based on Price earning multiple. Let’s understand the working of this structure and its usefulness in your investments portfolio.

Before going ahead, let’s first understand the 2 most important financial terms associated with this structure

 Asset Allocation:

Asset allocation in simple terms is Allocation/Distribution/ Division of investor’s total investment into different Asset classes. There are 4 asset classes where one can invest into i.e. equity, debt, gold or real estate. Whatever investment product you purchase you will get allocated into these mentioned asset classes only. (Also read Mutual fund case Study)

Price to earnings Ratio (PE ratio):

Price earnings ratio is calculated as Market price of share divided by Earning per share. Market price always embraces the sentiments along with, which may or may not depict the right picture. If investors are bullish on stock performance they will keep on buying and thus raises the Market price of shares and opposite happens when they are bearish.

On the other hand earning per share comes out of actual data and is the net profit earned by company divided by the number of shares.

If sentiments are high as it is now a days and earnings are low then you will get high PE multiple, and when prices are low and earnings are high then the PE multiple would be low.

This is what is looked at to figure out if the market is in fair value zone or expensive or cheap zone.

How the Dynamic Asset allocation in Mutual funds works?

These kinds of funds, generally comes under the structure of Fund of fund schemes i.e. one Mutual fund invest in other different Mutual funds. They have set criteria based on price to earnings ratio of Nifty or any other benchmark as to at what level what percentage of portfolio should be into equity and what into debt.

Let’s take example of Franklin India Dynamic PE ratio fund which is the oldest fund in this category having a track record of more than 10 years. This fund has Franklin India Blue-chip fund for equity allocation and Franklin India short term income plan for debt allocation.

It works on the following mentioned strategy and portfolio as on Aug 2014 is also as follows.

One thing to note here is that these kind of funds don’t look at your personal risk tolerance level or goals for asset allocation, but only the nifty or Sensex valuation

The strategy clearly tells that when PE ratio of Nifty increases the fund keeps on reducing the equity component.

Every fund house which has come up with such strategy has a predefined allocation band. Most of the funds have been recently launched so there performance can’t be commented on as it has not seen much of market movements.

Some funds of this category are HDFC Dynamic PE ratio FOF, BOI AXA equity debt rebalancer fund, and IDFC is coming out with a new fund naming IDFC Dynamic equity fund.

But Franklin Dynamic PE fund has 11 years track record, so we can figure out if the strategy has worked or not.

Points to keep in mind while selecting Dynamic asset allocation Mutual funds

1. As most of such structure comes in fund of fund category and thus attract taxation of debt mutual funds i.e. Short term capital gain (before 3 years) will be added in total income and Long term capital gain will be taxed @ 20% after indexation.
2. You have to look at the performance of underlying funds too.
3. As most of the funds under price to earning structure is new, so you should give time to them to see how they perform in
4. These funds don’t look at your personal risk tolerance level, so it might happen sometimes that when you should stay away from stock market, this fund would give you 60%.
5. If you are already following a financial planning model, then PE oriented dynamic asset allocation funds can increase confusion while rebalancing of your overall portfolio

 (If you want to have long term , goal based mutual funds portfolio, click here)

Who should invest in these dynamic asset allocation Mutual funds?

1. Those who understand that timing the market is a waste of time and are happy with decent return at average risk, then you can consider these funds
2. If you have a single goal targeted for medium term (4-5 years), then Hybrid funds in general and PE oriented dynamic asset allocation mutual funds in particular are best suitable one.
3. If you don’t follow financial planning and don’t have any set asset allocation to follow, then also you may consider these funds.

Overall, I find the Dynamic asset allocation concept nice, for 2 reasons. One it works on a set process and other it has auto asset allocation strategy. Both these techniques are very much required in a well-managed investment portfolio.  (Also Read: Balanced Advantage Funds vs. Multi-Asset Funds)

How do you find this dynamic asset allocation based on price to earnings ratio? Do share your opinion.