The Balancing Act Of The Balanced Advantage Fund

Mutual funds have had massive inflows over the last two to three years, but one category has become a preferred choice. Balanced advantage funds (BAFs), also known as dynamic asset allocation funds, are highly regarded by both investors and advisers. In the past one year alone, six new BAFs have entered the market, contributing to the category's impressive AUM of ₹1.923 lakh crore. It now trails only the Large-Cap and flexi-cap equity fund categories in terms of popularity.

The BAFs’ pledge to address market volatility in order to ensure a more comfortable journey towards wealth-building is the main draw for investors. These funds are advertised as offering the best of both worlds because they protect the portfolio from losses while yet allowing for profits. Let's examine what proportion of individual funds' performance depends on their allocation strategies and whether you should include these funds in your portfolio.

Asset Allocation
According to market conditions, BAFs dynamically adjust the allocation to stock and debt. However, there are many different ways they accomplish this. Within a range of 30 to 80 per cent, certain funds change the equity allocation. Others are free to maintain an equity allocation that ranges from 0 per cent to 100 per cent. In addition to making decisions on asset allocation, BAFs actively hedge equity positions, which further reduces losses during economic downturns. 

These funds may heavily invest in derivatives or arbitrage bets to artificially dilute equity allocation when market conditions call for modest exposure to equities. Even while the fund's overall equity exposure is kept at 65 per cent in such situations, the net equity exposure, when hedged positions are taken into account, is much lower. To take advantage of the tax breaks offered to equity funds (long-term capital gains up to ₹1 lakh are exempt from tax; gains over that amount are subject to a 10 per cent tax; short-term gains are subject to 15 per cent tax), this is crucial.

Triggers
The way that BAFs’ asset allocation calls are initiated is its most important feature. The only category with such a wide range of services, this shift is often determined by the internal models of fund houses and can be governed by very varied laws. For certain funds, values serve as the catalyst for moving capital into or out of the equity market. When stocks are costly, they increase their exposure to bonds, and vice versa. This results in a countercyclical strategy of buying cheap and selling high.

To determine how much money to allocate, funds use criteria like price to earnings (PE), price to book value (PBV), earnings yield, or a mix of several such metrics. Others use a pro-cyclical or trend-driven strategy, which moves with rather than against the market trend. In an upturning market, they allocate more to stock, and in a downturn, less. Additionally, BAFs use a variety of methods in their bond and equities portfolios.

While some have a substantial presence in broader markets, others invest primarily in stocks that are in the spotlight. Some bond funds alternate between long-term and short-term bonds or employ high-yield credit strategies (bonds with poor credit quality), while others choose high-grade bonds and place a strong emphasis on accruals. These variations, along with the various asset allocation strategies, can provide various results. Additionally, this category was created in 2018. These funds are either parachuted in from another category or were formerly balanced funds that dabbled in derivatives. Because many BAFs currently only have a small track record, it is difficult to evaluate their effectiveness in a meaningful way.

Optimization
The asset allocation models of these BAFs frequently don't perform their job well. The limits of valuation-based triggers in counter-cyclical models are particularly obvious during sudden changes in the market. These models are not as flexible as thought and can make mistakes.

For instance, several funds were caught off guard after the March 2020 crisis. Index valuation multiples decreased when stock prices plummeted, causing valuation-centric models to increase equity exposure to the maximum level. However, the increased stock exposure damaged these funds as the markets fell further.

Even funds that prioritise market trends over values are rarely perfect. When the market trend is predictable, they perform well. Later, as the market's momentum changed for the better, the model increased equity exposure and allowed the fund to profit from the increase. It can be challenging to understand how a fund operates because not every AMC explicitly explains the nuances of its model. In back-tested data, the model is frequently shown to work well, but results in real time can vary substantially.

Notions about BAFs
Dispelling certain myths about BAFs is necessary. They may not be all-season investments. Although the drawdown during market downturns will be limited by the debt component of such funds, the fund is not entirely insulated from losses. These funds seek to prevent full loss exposure rather than falling together with the market. While some BAFs are skilled at absorbing losses, not all funds can do this consistently.

In the past, BAFs have been mis-sold as a source of regular income through SWPs. The SWP facility was promoted as a reliable source of monthly income. When taken from a low volatility fund, SWPs function well. Although BAFs may be less volatile than pure equity schemes, they are not appropriate for frequent income withdrawals. Over the past three years, these funds have posted six-month losses 24 per cent of the time on an average. Therefore, SWPs from a BAF run the danger of being redeemed at a loss as the value of the source fund declines.

Secondly, a BAF doesn't truly address your issues with asset allocation. Anyone who makes such a claim is misleading. People may have other investments even if they do not invest in any other mutual funds. How can the asset allocation of the entire portfolio be controlled by a single fund? Furthermore, there is no one-size-fits-all approach to asset allocation. Individual risk profiles can differ, requiring various asset combinations that cannot be controlled by a single fund.

When to Invest in BAF
These are essentially risk-mitigation solutions designed to reduce volatility and are only appropriate for specific investors. For cautious investors looking to move up the risk scale, BAFs can be helpful. Without taking on excessive risk, the growth assets will support the return on the portfolio. In order to lessen portfolio volatility, investors with a significant equity exposure may also invest in BAFs.

These funds may offer comfort to investors who become uneasy during periods of excessive volatility. However, because BAFs restrict the amount of market value that can be extracted, seasoned investors can avoid them. The actual value of BAFs is in their ability to control investor emotions. Investors frequently leave volatile markets out of fear. When prices have already risen, they return, only to be let down when the markets decline once again. Others leave the market too soon, losing the chance to make money.

A BAF shields an investor from making emotional errors by reducing drawdowns. Real wealth building ultimately depends on maintaining an investment portfolio. BAF does not satisfy everyone. However, it is a respectable fund type and offers a high return outcome without much risk, which is sufficient for many investors.

Right Fund Selection
The fundamental idea of investing in a BAF will be defeated if you choose a fund based on returns. These funds aim to lower volatility while maintaining a respectable upside. They are not designed to provide large returns over an extended period of time. The highest return fund might not always be the best one. Invest in pure equities funds if returns are your top concern. The importance of downside protection must be emphasised. Pick a fund based on how it performed during a downturn.

A fund that underperforms the market is ideal for providing some solace when things are tough. Choose from funds with tried-and-tested allocation models. The past performance can be used as a predictor of future behaviour because these decisions about asset allocation are frequently based on rules. As always, it is better to stay away from NFOs or new, untested funds.