Asset Allocation Funds are funds which are invested in a diverse array of asset classes including equities, fixed income, cash, and alternative investments.
Table of Contents
- 1 What is meant by Asset Allocation Funds?
- 2 Explaining Asset Allocation Funds
- 3 Logic Behind these Funds
- 4 Dynamic Asset Allocation Funds
- 5 Operation of Dynamic Asset Allocation Funds
- 6 Disadvantages of Dynamic Asset Allocation Funds
What is meant by Asset Allocation Funds?
Asset Allocation Funds are investment vehicles which provide exposure across asset classes. The key investment philosophy behind Asset Allocation Funds is diversification.
These funds invest across the equity, fixed income, cash and cash equivalent asset classes, as well as alternative investments like gold and metals, among others. They can also include arbitrage as an investment strategy and can invest across geographies as well in order to deepen their diversification.
These funds intend to offer lower volatility than a typical equity fund and provide higher returns than a debt fund would.
Explaining Asset Allocation Funds
When we talk about using funds for investing, we usually categorize them in one of two buckets – equity or debt funds. Though equity funds provide a little exposure to the fixed income asset class, it is primarily a short-term bet aimed mostly at cash management.
However, there are funds which can be classified as ‘hybrid.’ These funds can also be known as balanced funds and unlike a dedicated equity or debt fund, they have a defined range of exposure to equity, fixed income, cash, and alternative investment classes. For instance, they may invest 50-60% of their assets in equities, 30-40% in bonds, and 10-20% in cash; this break-up would be available in scheme documents and the fund will adhere to the stated allocation at all times.
Logic Behind these Funds
These funds give investors a clear idea about where their money is being deployed as well as what the minimum and maximum limits are. Apart from assisting in diversification across asset classes, Asset Allocation Funds can provide a suitable starting point for the first time or conservative investors to give them a taste of equity and fixed income investing without exposing them to too much volatility.
Though this relatively static allocation has been a characteristic of Asset Allocation Funds, it is not to say that these funds do not have anything to offer to more adventurous investors.
Dynamic Asset Allocation Funds
Dynamic Asset Allocation Funds do not place the portfolio weight restrictions that traditional balanced funds do. Though these funds also invest across asset classes, they offer a much higher flexibility in asset allocation than their balanced fund peers. If the market conditions so demand, Dynamic Asset Allocation Funds can be completely invested in equity or debt.
Operation of Dynamic Asset Allocation Funds
These funds change the allocation of their portfolio based on quantitative models which make use of metrics which determine the valuation of the underlying asset classes. For instance, if the quantitative model indicates that a price-to-earnings (P/E) ratio of over 25 is expensive, the fund can completely pull out of equities and invest only in bonds when the metric breaches that level. On the other hand, if the same model is designed to consider a P/E ratio of below 10 as cheap, then the portfolio can be solely invested in equities if such a scenario materializes.
Similar parameters can be placed for fixed income securities as well and combined, they determine the asset mix of the portfolio.
By use of these quantitative models, the fund ensures that investors avoid the mistake of buying high and being forced to sell low by dynamically changing the allocation to asset classes based on valuation and other metrics.
Due to their investment strategy, Dynamic Asset Allocation Funds may look like optimal investment vehicles, but they are not without some pitfalls.
Disadvantages of Dynamic Asset Allocation Funds
In a rising equity market, a pure equity fund may easily outperform a Dynamic Asset Allocation Fund. This can happen if the quantitative model dictating asset allocation in the latter hits the ceiling of its parameters thus indicating a shift towards fixed income securities but the equity market continues going up. Due to this, investors need to remain invested in these funds for a long-term to benefit from a complete business cycle.
There’s an element of cost too. If the parameters forming the quantitative model are breached frequently, it would result in a repeated rebalancing of the portfolio and this trading would increase the cost of administering the fund. This can result in underperformance of the fund vis-à-vis an equity fund which will stay the course until the portfolio manager thinks otherwise.
It is important for investors to note that there is no standardized quantitative model which determines the asset allocation of these funds. Every fund provider has its own model, which means that each offering can react differently to the same market conditions.
Style of Investing
Further, even though Dynamic Asset Allocation Funds have a quantitative model dictating the asset allocation, it does so only a broad asset class level. It is still a portfolio manager and his investment team which picks the individual securities comprising these asset classes. Thus, even if two funds follow the same quantitative model but are managed by two different portfolio managers, they can yield different results based on their manager’s security picking ability.
Use in Retirement Planning
Asset Allocation Funds also find use in retirement planning, though in a different format from balanced or dynamic funds. They are known as life-cycle or target-date funds. Their asset allocation changes depending on the life stage of the investor or the target retirement date. They typically begin with a riskier asset allocation which becomes more conservative as the investor’s life cycle changes or the target date nears.
References:March 19th, 2018