Hybrid mutual funds are mutual fund schemes which invest in more than one asset class (e.g. equity, fixed income etc.). Asset allocation is one of the most important portfolio considerations for investors since it enable investors to balance risk and return for achieving their financial goals. While investors can balance their portfolio by investing in equity and debt mutual funds, hybrid funds provides both equity and fixed income exposure in a single scheme. Hybrid funds also provide tax efficient investment solutions. Hybrid funds of different categories provide investment solutions for different risk profiles, from aggressive to conservative profiles.
Balanced Advantage Fund is one of the most popular categories of hybrid funds.
What are Balanced Advantage Funds?
Balanced Advantage Funds are hybrid funds which manage their asset allocation between equity and fixed income dynamically based on quantitative asset allocation models. They are also known as Dynamic Asset Allocation Funds. There is no SEBI mandated upper or lower limit for equity or fixed income allocations for Balanced Advantage Funds. The funds use derivatives to hedge their equity exposures. Balanced advantage funds usually enjoy equity taxation. However, you should consult with your financial advisor to know the taxation of specific balanced advantage funds.
Dynamic asset allocation versus static allocation
- Hybrid funds which follow static allocation maintain their equity and fixed income allocations in a certain range. For example,aggressive hybrid funds maintain their equity allocation between 65 to 80% and fixed income allocation between 20 to 35%
- Balanced advantage funds change their asset allocation dynamically depending on market conditions. For example, the net equity allocation of balanced advantage funds can be as high as 80% in certain market conditions and as low as 30% in certain conditions.
- Aggressive hybrid funds can be quite volatile in bear markets. Balanced advantage funds are usually less volatile than aggressive hybrid funds.
Asset Allocation of Balanced Advantage Funds
- Active (net) equity: Active equity allocation or equity allocation net of hedging is determined by the dynamic asset allocation model (we will discuss dynamic asset allocation models in more details later).
- Fixed income: Fixed income or debt allocation is usually capped at 35% to avoid non-equity taxation.
- Arbitrage: This is the fully hedged equity component which is not exposed to market risks. The arbitrage component not only reduces risk (i.e. the net equity exposure)it also generates arbitrage (risk-free) profits based on price differences in cash and futures market or corporate actions. It also enables these schemes to enjoy equity taxation.
Dynamic Asset Allocation Models
Two types of dynamic asset allocation models are mainly used:-
- Counter-cyclical model: These models essentially aim at buying lowand selling high. Counter-cyclical models increase equity allocation (reduce debt allocation) in falling markets (lower valuations) and reduce equity allocations in rising markets (higher valuations). Different fund managers use different valuation metrics for dynamic asset allocation e.g. P/E, P/B etc.
- Pro-cyclical model: Pro-cyclical models essentially try to follow the trend. Funds employing pro-cyclical models increase their equity allocation in rising markets and reduce it in falling markets. Pro-cyclical models are based on market trend indicator (Daily Moving Averages) and indicators of the trend strength / health (Standard Deviation, Downside Deviation etc.). Some pro-cyclical models may use other factors like valuations, macro-economic factors etc.
Why pro-cyclical asset allocation?
The logic of counter-cyclical models is simple – you buy when prices are cheap and sell when prices are expensive. Pro-cyclical approach, though less talked about, is used extensively by global investors. The underlying logic in pro-cyclical approach is that market follows broad trends. If you are driving a car at a good speed, the car will keep going forward at fairly good speed even if you take your foot off the accelerator – the reason is momentum. Similar behaviour is observed in stocks. In a broad market uptrend, stock prices tend to go higher even if valuations are expensive. Similarly in a bear market, prices may continue to fall, even though valuations may appear to be very cheap. Pro-cyclical asset allocation aims to maximize returns in bull markets and tries to limit downside in bear markets by shedding risks quickly. The success of pro-cyclical asset allocation models depends on the robustness of the model in identifying the strength of a trend quickly.
Which model is better?
- Counter-cyclical models are simpler to understand.
- Since counter-cyclical models have low equity allocations at market tops, these funds tend to be relatively less volatile when markets correct.
- Stock price movement is not determined by valuations alone. Momentum can take stock prices to much higher levels despite high valuations. Past bull marketshave shown that momentum works in India.
- While counter-cyclical models are less volatile in short corrections, pro-cyclical models may see lesser drawdowns in deeper and longer corrections e.g. 2008 Global Financial Crisis. In a bear market, counter cyclical schemes will keep increasing equity exposure as market continues to fall and losses may increase. Pro-cyclical models on the other hand, will shed risks when market falls.
- One of the major advantages of Balanced Advantage Funds is that it follows a systematic, quantitative model for managing asset allocation, without relying on human judgement. The models are back-tested in different market conditions.
- You should understand which asset allocation model a balanced advantage fund is following. You should read the scheme information document (SID) to know how the dynamic asset allocation will work for the particular scheme.
- You should consult with a financial advisor if you need help in knowing the risk characteristics of a scheme or your own risk profile. You should always make informed investment decisions based on your risk appetite and investment needs.
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