Are BAFs the solution to asset allocation worries?

Balanced Advantage Funds (BAFs) or Dynamic Asset Allocation Funds (DAAFs) have become the dominant hybrid mutual fund category with an AUM (assets under management) of ₹1.64 trillion. Within BAFs, a particular model has also become dominant. This model uses derivatives to reduce effective exposure to any level that the fund manager thinks fit, while maintaining a gross equity exposure of 65%. This allows BAFs to be taxed as equity funds even if their actual equity exposure is minimal at times.

HDFC Asset Management Company, which until recently adopted a more static approach, avoiding the use of derivatives and keeping equity exposure between 65-80%, has also embraced the more dominant model and brought down its effective equity exposure to 57% as markets rose in 2021. Mirae Asset Mutual Fund, which had steered clear of BAFs, arguing in favour of its aggressive hybrid fund, has also filed for a BAF with the Securities and Exchange Board of India (Sebi).

SBI Mutual Fund, which launched its own BAF in August 2021, saw its assets swell to a record ₹20,000 crores by October.

However, accompanying the success of this category are allegations of mis-selling of BAFs. 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 funds for ‘all seasons’ and a solution to investors who want to allocate money between equity and debt. Our panel of experts explains what role BAFs should really play in investor portfolios.

BAFs can take care of tactical asset allocation

There are broadly two kinds of asset allocation (AA) strategies—tactical and strategic. A strategic AA is based on one’s goals, risk appetite and is done across wider asset classes like gold, real estate, etc. Tactical asset allocation, on the other hand, aims to drive benefit from volatility in an asset class by timing the entry and exit. It can be beneficial if done in equities as it is the most volatile asset class.

BAFs can take care of tactical asset allocation in equities since they increase and reduce equity allocation in a disciplined way using a pre-defined model. They aim to reduce drawdowns when markets are falling and participate in the upside reasonably well.

Doing tactical asset allocation into equities at the investor level is not tax-efficient and is also emotionally draining. In that context, BAFs can be a good solution for tactical asset allocation into equities and this one fund can take care of this piece very well. It can form the core part of investor’s portfolio in the long term.

New investors can use BAFs to dip their toes into equities

Asset allocation is the single 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 the debt/equity allocation based on market conditions, which may not match the investor’s financial circumstances, so investors would land up taking far higher or lower risk than they need to. While market timing may seem attractive, in the long term the incremental returns are only marginally higher. Instead of a one-size-fits-all approach, it is better to have flexibility to invest in large, mid, small and across durations of debt based on each one’s requirement.

For new investors, BAFs can be a good way to dip the toes into investing in equity and getting comfortable with the inherent volatility. Since they may lack the discipline to rebalance the portfolio as per the predetermined asset allocation, these funds rebalance automatically by removing human biases from the equation.

BAFs can help overcome behavioural biases

The common behavioural pattern seen among investors is to invest when market rallies even at higher valuations and pause when market corrects. This tends to hurt an investor in the long run and leads to suboptimal returns made on the investment. In order to address this investment flaw, ICICI Prudential Mutual Fund launched BAF more than a decade ago; a fund which invests in a counter-cyclical manner. Our objective was to get investors invested in a product, which will deliver a good risk-adjusted experience of investing even in volatile equity markets. The original genesis of the product was to buy low and sell high while keeping aside human emotions. The product was designed in a manner to benefit from market volatility and promoted across investor profiles. Therefore, the approach has to be conservative. Equity and debt are the largest financial asset classes. Hence, for asset allocation in financial asset classes, BAF is most apt as a product for all investors.

Relying on BAFs is akin to not having a strategy

BAFs cannot be a solution to investor’s strategic asset allocation. This is because the asset allocation of BAFs is dynamic, whereas the strategic asset allocation of an investor should follow a predicable glide path based on their financial goals. Relying on a BAF for asset allocation is akin to not having an asset allocation strategy. BAFs can only be used for tactical asset allocation calls where the investor outsources taking market direction calls to the fund manager. Apart from tactical asset allocation, the other case where BAFs can be useful is for financial goals which sit in the grey zone of the time continuum, i.e., for a financial goal which is neither imminent and hence requires only a debt allocation, nor a financial goal which is sufficiently far away and requires a full equity portfolio. In terms of risk, BAFs have greater downside protection compared to aggressive hybrid funds due to their flexibility of increasing allocation to debt investments.