Dynamic Mutual Fund: Should you go for it for better returns?

By: | Published: July 20, 2017 10:49 AM

Conceptually, dynamic mutual funds are in a way similar to balanced funds as they entail a mix of equity and debt in their portfolio. However, both the funds also differ in many respects.

dynamic mutual fund, balanced fund, equity, debt, better return, investmentThe advantage of investing in a dynamic fund is that you can play the market cycle more effectively.

Equity markets are trading at historical levels currently and, therefore, any investment avenue with exposure to equities is generally considered ideal for investment in the current scenario. Dynamic mutual funds, being one such avenue, are also believed to be a better choice for investors in a rising and volatile market. Conceptually, dynamic mutual funds are in a way similar to balanced funds as they entail a mix of equity and debt in their portfolio. However, both the funds also differ in many respects and investing in any of them would depend on one’s investment goal and risk appetite.

Dynamic mutual funds vs Balanced mutual funds

Dynamic mutual funds are schemes which can take dynamic asset allocation calls across debt, equity and arbitrage opportunities. They take 20-40% equity exposure to generate better return than plain debt investments. “They are classified as equity mutual fund because they take exposure in arbitrage opportunities to keep the required exposure of minimum 65% towards equity. The rest of the exposure is taken in debt investments to keep the volatility in check and generate regular income. The fund tries to generate alpha by active duration management, dynamic asset allocation, stock selection and sector rotation. These asset allocation and investment strategies vary from scheme to scheme and shall be read in the Scheme Information Document before investing in a particular scheme,” says Vikash Agarwal, Co-founder, CAGRfunds.

Returns from dynamic mutual funds can range from 10 to 15%, depending on the performance of the equity markets and the rebalancing calls taken by the fund manager.

A balanced fund also consists of a mix of equity and debt but in that case the proportion is normally 65% in equity and 35% in debt. Dynamic funds, on the other hand, can even go up to 100% in equity or 100% in debt as the case may be.

It is generally believed that investors who are trying to build their equity exposure for their long-term goals are better off investing in diversified equity-oriented schemes. However, people looking to invest lumsum money with an intention to generate better returns than plain debt investments may allocate money in these funds. “The equity markets are trading at historical levels with a trailing PE of 23, and these dynamic funds because of their dynamic asset allocation calls can maintain lower exposure of 20-40% which leads to lower volatility than other equity funds. However, they are still classified as equity investments for taxation purpose as they invest the balance in equity arbitrage opportunities. This dynamic asset allocation helps them to generate better risk adjusted returns with greater tax efficiency,” says Agarwal.

Pros and cons of investing in dynamic mutual funds

The advantage of investing in a dynamic fund is that you can play the market cycle more effectively. The disadvantage is that the performance depends on the fund manager’s ability to take advantage of the market cycle. He can outperform or underperform the market by a big margin, depending on his broad-based decisions on asset allocation.

“Conceptually, dynamic mutual funds have an advantage over balanced funds because they can shift between asset classes without restrictions, but is subject to the mandate of the fund. The flexibility to shift between equities and debt markets is mentioned in the offer document and it gives them the ability to play the market cycles much better. Balanced funds, on the other hand, cannot change the equity to debt structure (65:35) of their investments, regardless of whether the market corrects or not,” says Tejas Khoday, Co-Founder of FYERS, an investment platform.

The performance of any fund depends on the fund manager but this is truer in the case of dynamic funds because it gives the fund manager the liberty to choose his asset weightages. “By virtue of the mandate, he can change his portfolio from equity to debt and vice versa without restrictions. Of course, fund managers are generally conservative and would hesitate to make such drastic shifts from one asset class to another for the fear of being wrong. However, when market valuations start to peak, dynamic funds can sell on the way up instead of averaging on the way up and reinvest the sale proceeds in debt instruments,” says Khoday.

Currently, a majority of dynamic funds are in the debt segment (Dynamic bond funds) which play the longer end of the yield curve to generate more returns than regular debt funds. Dynamic equity funds are scarce, but this is primarily because they are disguised as regular equity funds which do not shift their asset allocation too much to make a difference.

The disadvantage of investing in such instruments can be for people who want to plan for their long-term goals and have limited exposure to equity. For such people, diversified equity mutual funds are better investments as they have to build an equity exposure for the long term.

“From a tax perspective, dynamic funds are treated as equity investments only if their equity portion is 65% and above. If it goes below that, the gains made from the fund will be taxed as per the tax slab applicable for debt funds. This is one of the main reasons why fund managers cannot switch from equity to debt aggressively,” says Khoday.

Which is for you

For retail investors who are making the shift from fixed deposits to mutual funds, balanced funds is a better choice as it is simple and straightforward to understand. They have a longer track record of performance and each fund can be compared to a large number of peers. However, people who have a higher risk appetite and are looking to generate better returns than plain fixed investments may look to invest in dynamic mutual funds.

“The choice between dynamic and balance fund completely depends on the goal, risk tolerance and time horizon of the investor. Given the greater flexibility in asset allocation it may capture some market opportunities better than balanced fund, but aggressive rebalancing may act at a handicap if the fund manager takes a wrong call,” informs Agarwal.

Precaution

Fund managers believe instruments like dynamic funds should not be subscribed purely on the basis of past returns. The past returns may not be replicated if the equity markets underperform as these funds have 20-40% equity exposure. However, given the exposure of 60-65% towards fixed income, it will be less volatile than pure equity funds or balanced funds when the equity markets underperform.

“The biggest precaution for such investments is to understand the risk and investors should not be swayed into such investments by simply looking at past returns. Investors should look at funds which have performed well across market cycles. Also, checking the fund house and the track record of the fund manager is important for selecting good funds,” says Agarwal.

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