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These two types of funds aim to manage market volatility. But one of them is more flexible than the other

Dynamic asset allocation and aggressive hybrid funds invest across equity and debt. But one maintains a steady equity allocation usually while the other swings wildly.

March 29, 2022 / 08:00 AM IST

Although every investor should have a presence across asset classes—or as we typically call it, asset allocation—the reality is that many investors do not. One easy way to correct this mistake is by allocating some portion of your portfolio to a mutual fund that does the asset allocation for you.

Broadly speaking, there are two types of schemes that do just this: dynamic asset allocation and aggressive hybrid funds . Both invest in equity and debt assets to balance capital appreciation and lower volatility. But there is one difference.

Structural Differences

Aggressive hybrid funds keep 65-80 percent in equities at all times. The remaining 20-35 percent should be in debt instruments. So structurally, this category cannot go below 65 percent and above 80 percent equity, and this allocation is diligently managed via periodic rebalancing by the asset management companies (AMCs).

But do note that this allocation is not dynamic as such. That is, it is only rebalanced back to originally chosen levels based on market movements. And this is where dynamic allocation funds have the upper hand.

Close

Dynamic asset allocation funds, as the name suggests, have the flexibility to be dynamic about their allocation decisions. They are allowed to change their equity allocation from zero to 100 percent. But practically, these tend to oscillate between 30 percent and 80 percent in equities.

And what decides the equity allocation of these funds? AMCs use different models that depend on qualitative factors (like price-earnings or price-to-book ratios, etc.) or quantitative ones. They also allow fund managers to use their discretion to decide allocation.

How do both funds differ operationally?

Suppose there is an aggressive hybrid fund with 60 percent equity allocation and a dynamic allocation fund with 80 percent in equity.

Suppose further that the market moves up sharply by 20 percent. This will result in an increase in equity allocation for both. This 20 percent rise in the market will result in equity allocation changing to 64 percent for the aggressive hybrid fund and 83 percent for the dynamic allocation fund.

Now, the aggressive hybrid fund, being statically managed, will bring back the equity allocation to 60 percent.

But the dynamic fund may not necessarily bring back the allocation to the original 80 percent. If the fund manager (or the model used) decides that the equity market is getting riskier, he may bring the allocation down to even 40 percent. That is the level of flexibility that the dynamic category has.

But all dynamic allocation funds are not the same . And there can be a lot of variances in the equity allocation of funds by different AMCs.

Difference in returns

Although both categories want to balance returns and risk (and hence have both equity and debt), there is a little more to it.

Due to their mandated nimbleness, dynamic funds aim to protect the downside when the market corrects sharply. This is also to curb volatility to some extent.

To be fair, there is no way to predict with certainty which category will outperform the other in the short term. So different years will throw up different winners between the two. But over the long term, both categories are expected to have similar return profiles but different volatility experiences in the short term.

Also, both categories are more about reducing the volatility in returns rather than trying to outperform the markets. But having said that, aggressive hybrid funds can give higher returns in a rising market compared to dynamic funds which have lower equity allocation. On the other hand, dynamic funds are expected to fall less during market falls due to their lower equity allocation in such times.

In my view, you should treat both categories as equity funds and, accordingly, be willing to hold for the long term (even though some AMCs promote these as good for even the short to medium term).

By the way, equity allocation aside, there can still be considerable overlap within the equity portfolio of both categories. So don’t pick the two together and hope for a well-diversified portfolio.

Choosing between the two

· If you want to maintain a solid equity allocation at all times, then use aggressive hybrid funds. They will always have a minimum of 60-65 percent equity allocation which is regularly rebalanced.

· If you want to outsource the asset allocation decision, then go with dynamic allocation funds. The fund manager will decide what the right equity allocation is at a given point of time and tilt the portfolio accordingly.

· If you want to have tactical equity allocation in your overall portfolio, then too you can go for dynamic allocation funds. Though it sounds glamorous, the fact is that managing your tactical allocation in equities at the investor level is mentally draining and not that tax-efficient either.

· But if you have a sufficiently large portfolio and want to decide allocations yourself (or are being advised by an investment advisor), then its best to manage your asset allocation using separate equity and debt funds.



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Dev Ashish The writer is the founder of StableInvestor.com
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