What are asset allocation funds?

You know there are balanced funds, which invest mostly in equity and some in debt. You know there are MIPs, which invest mostly in debt and some in equity. You know that these funds play around with the equity-debt ratio depending on the market. So what, then, are asset allocation funds? What it is To begin with, an asset allocation fund need not restrict itself to only equity and debt. It can combine equity, debt and sometimes gold in varying proportions or sometimes add arbitrage as an additional strategy to this asset allocation combination. Next, there are two groups of asset allocation funds. One group dynamically changes the allocations to each asset class depending on several indicators. The second group is like a regular balanced fund or MIP with set ranges for each asset class. Funds in the first group are dynamic asset allocation funds. These funds are extremely flexible in how much of the portfolio they allocate to each asset class. Balanced and debt-oriented hybrid funds have strictly defined allocations within which they operate. An MIP, for instance, will never move beyond 30% in equity no matter how attractive stocks look, nor will it completely divest itself of equity. Truly dynamic asset allocation funds are not restrictive. They can go all into debt or all into equity if the situation so demands it. They use a set of parameters to decide the asset-wise breakup of the portfolio. This break up will change dynamically depending on the performance and prospects of each asset class. If, for example, equities have run beyond what the fundamentals support and are overvalued, the fund can shift significantly away from equity and move into debt. A balanced fund can at best reduce equity to 65%. Take Franklin India Dynamic PE Ratio Fund-of-funds for example. This fund uses the Nifty PE and defines six PE bands with a corresponding equity-debt breakup. If the PE is above 28 times, the fund can pull equity to nil and invest entirely in debt. If the Nifty PE is between 20-24 times, equity can be 30-50% of the portfolio. A PE below 12 times can see the portfolio entirely in equity. In another example, DSP BR Dynamic Asset Allocation fund uses the ratio between the 10-year G-Sec yield and the earnings yield of the Nifty index to determine its asset allocation. For this fund, both debt and equity can be 10-90% of the portfolio. SBI Dynamic Asset Allocation fund also has 0-100% in debt and equity, and uses momentum indicators such as moving averages for the Sensex and the G-Sec yield to decide on allocations. UTI Wealth Builder combines equity, arbitrage, debt, and gold with allocations based on a model that considers several factors such as valuations, momentum, and earnings sentiment. The second group of funds are plain hybrid funds, except that they can involve any combination of assets. These funds are not dynamic and have a pre-defined range for each asset class, just as it is in a balanced fund or an MIP. Most asset allocation funds are built in such a manner. Axis Triple Advantage, for example, has equity, debt, and gold, of which the first two are 30-40% of the portfolio and gold is 20-30%. Then there is Kotak Multi Asset Allocation and Invesco India MIP Plus, which are predominantly debt-held with some exposure to both gold (its a 10% minimum in the Invesco fund) and equity. Canara Robeco InDiGo has 65-90% in debt and the rest in gold. The difference between the two groups is that in a dynamic asset allocated fund, you aren’t really certain whether it is equity-oriented or debt. In the others, you are certain of the orientation of the fund and the approximate return expectation over the long term. More, in dynamic funds, the tax implication for you depends on the fund’s average equity holding in the twelve months before the date of your sale. Some funds, such as UTI Wealth Builder work around this by using arbitrage to maintain an equity exposure above the 65% threshold. Suitability Asset allocation funds will deliver only if held over the long term, because the effect of juggling asset classes will show only over market cycles. They also suit only conservative investors, since the changing allocations when returns have rallied help book out at highs and keep volatility down. If you already own funds across asset classes, including these in your portfolio may not have a significant impact. Note that where funds have equity, the shifting of assets means that returns will not match equity or even balanced funds in the long-term. Where funds combine debt and gold, an underperformance of the latter can pull returns below pure debt funds as well.