The advantage of mutual funds over pure equity, bonds, precious metals, or real estate investment is that they have inbuilt risk management system. They invest in a set of assets to fend off any risk that arises because of single asset or a set of assets which are facing temporary slowdown. They also have someone, the fund manager, who is keeping a track of your investment and changes the assets depending on how they perform and the future prospects. Let’s look at asset allocation fund which is growing in popularity.

 

Asset allocation funds

These types of funds are also known as fund of funds because they invest in different types of funds such as equity funds, bond funds, balanced funds with a mix of equity and bonds. The idea behind fund of funds is that one fund can meet your requirement. It is a tall claim though. We would not suggest investors invest in just one asset allocation fund.


Asset allocation funds can be of two types; static and dynamic. Static asset allocation funds are those that invest in a set of assets with pre-defined percentage of funds allocated. This proportion doesn’t change with changing situation of market. This type of fund is very few and far between.

 

Dynamic asset allocation funds

Dynamic asset allocation funds change the proportion as per the market situation. For example, when the market is closer to its peak value, these funds invest a very small part of funds in equity mutual funds while investing major part in bond funds. This helps them protect investors’ money in case of a market slowdown. Similarly, when the market is closer to bottom, these funds put a major part of money in equity mutual funds and a very small part in bond funds. By investing major part of fund in equity mutual funds, they can take advantage of bull market. Fund managers use different ways to decide whether markets are closer to peak or closer to bottom consequently deciding the proportion to be invested in equity mutual funds and debt mutual funds. The most popular method is to use PE ratio of market.


The way this works is very simple but yet very effective. PE ratio of market or stock is a good indicator of relative valuation. A higher PE shows higher valuation while a low PE indicates undervalued asset. The fund looks at PE and allocates higher proportion to market when the market PE is lower. It reduces the proportion as the market PE goes up. The reason is that when the PE goes up, market becomes more expensive and it is reasonable to expect that it will come down too.


Typically, when the PE ratio exceeds 20, it is time to reduce proportion invested in equity mutual funds and subsequently increase the proportion in bond funds. On the other hand, when the market PE is below 12, it is great time to increase your proportion in equity funds and reduce the same in bond funds. Almost all dynamic funds define their proportion as per market PE.

 

Example of asset allocation funds

Fund houses have been pretty bullish about the dynamic asset allocation funds. The best part about these funds is that investors do not have to worry about asset allocation on their own. Most of the investors are ignorant about it. Let’s take a look at few funds in this category and how they performed.

 

Name of the fund

Last 3 months

Last 1 Year

Last 3 Years*

Last 5 Years*

FT India Dynamic PE Ratio Fund of Funds

4.03%

6.90%

7.13%

9.23%

ICICI Pru Dynamic

3.58%

10.04%

10.02%

8.33%

NIFTY Returns

5.97%

7.48%

3.76%

3.93%

 

Look at the performance carefully. The difference in the returns between the FT India fund and the ICICI fund is because how they allocate assets based on their criteria (could be based on market PE which is generally used).


At the same time, take a look at the performance of these funds with respect to the performance of NIFTY. Clearly, these funds would perform better when the market is not bullish or relatively less bullish. However, when the market is bullish, these funds will underperform. The best value proposition of these funds is that they never give negative returns because of inherent asset allocation mechanism.

 

Note:This table will give a fair idea about the asset allocation strategy of FT India dynamic PR ratio fund of funds. Other fund houses may use similar criteria.This table is taken from FT India website.

 

Weighted average PE ratio of NSE Nifty

Equity Component (%)

Debt Component (%)

Up to 12

90-100

0-10

16-Dec

70-90

30-Oct

16-20

50-70

30-50

20-24

30-50

50-70

24-28

30-Oct

70-90

Above 28

0-10

90-100

 

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