Balanced advantage mutual funds: Have they delivered, who should invest, how to pick right scheme

In the past 2-3 years, mutual funds have seen enormous inflows but one category has emerged a favoured pick. Dynamic asset allocation funds, or balanced advantage funds (BAFs), have achieved a haloed status among investors and advisers alike. Six new BAFs have come in the past one year alone, helping the category amass a huge AUM of Rs.1.83 lakh crore. It now ranks behind only the large-cap and flexi-cap equity fund categories. The big attraction for investors is the BAF promise of tackling market volatility to ensure a smoother ride to wealth creation.

These funds are being touted as the best of both worlds—they cushion the portfolio against downsides, yet are able to benefit from upsides. Our cover story this week examines whether BAFs can deliver on this promise. We also look at how much hinges on the allocation models that govern individual funds and whether these funds should find space in your portfolio.

Promises aplenty

BAFs dynamically adjust the allocation to equity and debt according to market conditions. But there are wide variations in how they do this. Some funds shift the equity allocation within a band of 30-80%. Others have the flexibility to keep the equity allocation from zero to 100%.

Apart from asset allocation calls, BAFs also actively hedge their equity positions, which further helps limit losses during downturns. When market conditions warrant low exposure to equities, funds may extensively take positions in derivatives or arbitrage bets to artificially dilute equity allocation. The net-equity exposure, adjusted for hedged positions, is much lower in such instances even as the fund’s aggregate equity exposure is maintained above 65%. This is important to enjoy the tax benefits given to equity funds (up to Rs.1 lakh long-term capital gains are tax free, and beyond that taxed at 10%, while short-term gains are taxed at 15%). In July, DSP Dynamic Asset Allocation Fund was sitting on 66% gross equity allocation, but had hedged 25% of the portfolio so its net equity exposure was lower at 41%.

Singing different tunes
The most critical aspect of BAFs is how their asset allocation calls are triggered. This shift is typically guided by the internal models of fund houses and can be governed by very different rules. Swarup Mohanty, CEO, Mirae Asset Global Investments, observes, “Not all BAFs are the same. This is perhaps the only category which has highly disparate offerings.” For some funds, valuations are the triggers for shifting money into or out of equities. They hike exposure to bonds when stocks are expensive and vice versa, which translates into the counter-cyclical approach of buying low and selling high.

Anish Teli, Founder, QED Capital, observes, “Counter-cyclical BAFs work on the premise that markets eventually revert to the mean.” Funds rely on metrics like price to earnings (PE), price to book value ( PBV), earnings yield or a combination of multiple such metrics to guide the asset allocation. Aditya Birla SL Balanced Advantage Fund and PGIM India Balanced Advantage rely on the PE multiple to guide asset mix while

Balanced Advantage goes by the PBV. Some like L&T Balanced Advantage and the new offering Franklin India Balanced Advantage use a combination of PE and PBV in their models. Others follow a pro-cyclical or trenddriven approach, which goes along with market trend and not against it.

They go with higher equity allocation in a rising market and lower in a falling market. DSP Dynamic Asset Allocation Fund, Kotak Balanced Advantage Fund and Nippon India Balanced Advantage Fund deploy a mix of valuation and trend indicators. Balanced Advantage runs a pure trend-based model that uses a combination of momentum and volatility factors as core indicators to identify market trend and its sustainability.

Till recently,

Balanced Advantage roughly maintained a 70% exposure to equities but now follows a more dynamic model in line with peers. BAFs also pursue varied strategies within the equity and bond portfolios. Some invest mostly in frontline stocks while others have sizeable presence in broader markets. Within bonds, some funds take active duration calls (switching between long and short term bonds) or run high-yield credit strategies (bonds of low credit quality) while others go for high grade bonds and focus on accruals.

These variances in the investment strategies is reflected in the disparate risk profiles of BAFs (
see table). Together with the varied asset allocation models, these differences can lead to varied outcomes. Besides, this category was carved out only in 2018. Funds in this category have either been parachuted from a different category or are the erstwhile balanced funds that also dabbled in derivatives. So, many BAFs have a limited track record in their present form, which hinders a meaningful analysis of their performance.

Finding the right mix

Are the asset allocation models of these BAFs doing their job well? Not always, is the short answer. Santosh Joseph, Founder, Germinate Investor Services, says “These models are not as nimble as perceived and can get caught on the wrong foot.” The limitations of valuation-based triggers in counter-cyclical models are most evident during sharp market swings. Ashutosh Bhargava, Fund Manager and Head-Equity Research, Nippon India Mutual Fund, points out, “A purely valuation- based allocation model will not come in handy when the market cut or rebound is very sharp and swift.”

For instance, during the crash of March 2020, many funds were caught on the wrong foot. As stock prices tanked, index valuation multiples shrunk, prompting valuationcentric models to hike equity exposure to the upper limit. But as markets dipped further, the incremental equity exposure hurt these funds.

Funds that rely on market trends over valuations are not infallible either. They work best when the market trend is discernible. During the March 2020 sell-off, Edelweiss BAF kept a modest 35% equity exposure even as other funds hiked allocation to stocks. This protected the fund from 60% of the 38% slide in the Nifty. Later, as market momentum shifted positively, the model hiked equity exposure and let the fund capture the upside.

But this pro-cyclical or trend-based model has limited utility in a sideways market. Between October 2021 and July 2022, the market was listless. Edelweiss BAF cushioned 26% of the Nifty declines. However, history suggests such non-trending market conditions do not continue for long. Besides, models should be judged on how they perform over a market cycle, not specific phases.

Not every AMC clearly spells out the intricacies of its model, making it difficult to get a clear grasp of a fund’s working. Often, the model is proven to work wonders in back-tested data, but outcomes can greatly differ in real time. Teli avers, “It can be difficult to execute the model consistently at larger size.”

Don’t get caught up in hype

Certain notions about BAFs must be dispelled. They are not necessarily all-season funds. A leading fund house proclaims that with BAFs, “investor wins irrespective of what direction the market takes”. This is not correct. While the debt portion in such funds will limit the drawdown during market declines, the fund is not protected from losses altogether. Mohanty insists, “These funds aim to protect from full extent of loss and not fall in tandem with the market.” Even as certain BAFs are adept at cushioning losses, not all funds can do this uniformly.

In the past, BAFs have been missold as a source of regular income through SWPs. The SWP facility was pushed as a safe monthly income option. SWPs work best when drawing from a low volatility fund. BAFs may have low volatility when compared to pure equity schemes, but they are not suited for regular withdrawals for income. On average, these funds delivered 6-month losses 24% of the times over past three years. So, SWPs from a BAF runs the risk of redeeming at losses while the source fund erodes in value. In contrast, only one ultra-short duration fund and no liquid fund incurred 6-month losses. Finfix Research & AnalyticsFounder Prableen Bajpai insists, “BAFs are not necessarily low on volatility during market extremes.”

Secondly, a BAF does not really solve your asset allocation problems. Anyone suggesting otherwise is misselling. Mohanty admits, “The way these funds are sold is a concern. For any fund to qualify as an asset allocation solution, you must put entire money in that scheme so that this fund itself covers your entire asset allocation.” Even if not investing in any other mutual fund, individuals may have other investments. How can one fund drive the asset allocation of the entire portfolio? Also, asset allocation is not a one-size-fits-all concept. Individual risk profiles can vary, warranting different asset mixes which can’t be fixed by one fund.

What BAFs are ideal for
Essentially, these are risk-mitigation products geared to limit volatility and only suit certain investors. Mohanty asserts, “BAFs can be useful for conservative investors who wish to step up the risk ladder. The growth assets will prop up portfolio return, without taking undue risk.” At the same time, investors with a high equity exposure may invest in BAFs to reduce the portfolio volatility. “These funds can help smoothen the ride for equity investors,” says Bajpai. Investors who get jittery during high volatility may also find solace in these funds. But savvier investors can avoid them because BAFs limit the extractable value from the market, argues Joseph.

The real utility of BAFs lies in how they manage an investor’s emotions. When markets are volatile, investors often exit out of fear. They return when prices have already run up, only to be disappointed when markets dip again. Others exit too early, missing the opportunity to create wealth. By limiting the drawdowns, a BAF prevents an investor from making emotional mistakes. Staying invested is what ultimately facilitates meaningful wealth creation. Radhika Gupta, CEO, Edelweiss AMC, remarks, “Is BAF perfect? No, it is not chocolate cake, and it doesn’t make everyone happy. But it is a decent dal chawal and delivers a good return outcome without too much downside. That is good enough for many investors.”

How to select the right BAF

Select a fund based on returns will defeat the very purpose of investing in a BAF. These funds are meant to reduce volatility while ensuring a decent upside. They are not geared for delivering high returns over the long term. So, the best fund may not be the one with highest returns. If returns are a priority, go for pure equity funds. The emphasis must be on the downside protection. “Choose a fund on the basis of its performance during a downturn.

A fund falling lesser than market is apt for giving some comfort during bad phases,” says Bajpai. At the same time, the fund should be able to offer a healthy participation in the market upside. Funds like DSP Dynamic Asset Allocation, Edelweiss BAF, ICICI Prudential BAF,

BAF and Union BAF have exhibited these qualities in the past. Pick from funds whose allocation model has been time-tested. Since these largely take rules-based calls on asset allocation, the track record can be an indicator of its future behaviour. And, as always, avoid new untested funds or NFOs.

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