Are BAFs the solution to asset allocation concerns?
Balanced Advantage Funds (FBA) or Dynamic Asset Allocation Funds (DAAF) have become the dominant category of hybrid mutual funds with an AUM (assets under management) of ??1.64 trillion. Within the BAF, a particular model has also become dominant. This model uses derivatives to reduce the effective exposure to any level the fund manager deems appropriate, while maintaining gross equity exposure of 65%. This allows BAFs to be taxed like equity funds even though their actual exposure to equities is sometimes minimal.
HDFC Asset Management Company, which until recently took a more static approach, avoiding the use of derivatives and keeping equity exposure between 65% and 80%, also adopted the more dominant model and reduced its effective exposure to equities to 57% as markets rose in 2021. Mirae Asset Mutual Fund, which had avoided BAFs, advocating for its aggressive hybrid fund, also filed a BAF application with the Securities and Exchange Board of India (Sebi ).
SBI Mutual Fund, which launched its own BAF in August 2021, saw its assets reach record ??20,000 crore by October.
However, the success of this category is accompanied by allegations of mis-selling by BAF. This has parallels with the mis-selling of hybrid funds in general in the post-demonetization era of 2017-18, when they were sold on the promise of fixed returns.
The flexibility built into BAFs allows them to be marketed as an “all season” fund and a solution for investors who want to split their money between equity and debt. Our panel of experts explains what role BAFs should really play in investor portfolios.
BAFs can handle tactical asset allocation
There are basically two types of asset allocation (AA) strategies: tactical and strategic. A strategic AA is based on goals, risk appetite and is done on broader asset classes like gold, real estate, etc. Tactical asset allocation, on the other hand, aims to take advantage of the volatility of an asset class by timing entry and exit. This can be advantageous if done in equities as it is the most volatile asset class.
BAFs can take care of the tactical allocation of equity assets as they increase and decrease the equity allocation in a disciplined manner using a predefined model. They aim to reduce drawdowns when the markets are down and participate reasonably well on the upside.
Carrying out tactical allocation of assets to equities at the investor level is not tax efficient and is also emotionally draining. In this context, BAF can be a good solution for tactical asset allocation in equities and this fund can take care of that part very well. It can form the core of the long-term investor’s portfolio.
New investors can use BAFs to get into stocks
Asset allocation is the most important factor in any portfolio. 90% of your returns are determined by your asset allocation, 5% by product selection and 5% by market timing. In BAFs, the fund manager decides on the debt / equity allocation based on market conditions, which may not match the financial situation of the investor, so investors would end up taking much higher risks. or lower than they should. While the timing of the market may seem attractive, over the long term, the differential returns are only slightly higher. Instead of a one-size-fits-all approach, it is better to have the flexibility to invest in large, medium, small and long term loans depending on individual needs.
For new investors, FBAs can be a good way to get started in investing in stocks and familiarize themselves with the inherent volatility. Since they may lack the discipline to rebalance the portfolio according to the predetermined asset allocation, these funds rebalance automatically by removing human biases from the equation.
ABF can help overcome behavioral biases
The common pattern of behavior seen among investors is to invest when the market rallies, even at higher valuations, and pause when the market corrects. This tends to hurt a long term investor and leads to suboptimal returns on the investment. In order to remedy this investment flaw, ICICI Prudential Mutual Fund launched BAF over ten years ago; a fund that invests counter-cyclically. Our aim was to encourage investors to invest in a product that will provide a good risk-adjusted investment experience, even in volatile equity markets. The original genesis of the product was to buy low and sell high while keeping human emotions out. The product has been designed to take advantage of market volatility and promoted through investor profiles. Therefore, the approach must be careful. Equity and debt are the main classes of financial assets. Therefore, for asset allocation in financial asset classes, BAF is the most suitable product for all investors.
Relying on the BAF is like not having a strategy
FBAs cannot be a solution to the strategic asset allocation of investors. Indeed, the asset allocation of BAFs is dynamic, while the strategic asset allocation of an investor must follow a predictable trajectory according to his financial objectives. Relying on an FBA for asset allocation is like not having an asset allocation strategy. BAFs can only be used for tactical asset allocation calls where the investor subcontracts market direction calls to the fund manager. Aside from tactical asset allocation, the other case where BAF can be useful is for financial goals that are in the gray area of the time continuum, i.e. a financial goal that is neither imminent. and therefore only requires a debt allocation, nor a sufficiently distant objective requiring a full portfolio of stocks. In terms of risk, BAFs have greater downside protection compared to aggressive hybrid funds due to their increasing allocation flexibility to debt investments.
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