All About Dynamic Asset Allocation Funds and Their Tax Implications

As the very name suggests, the Dynamic Asset Allocation funds refer to the type of mutual funds that are dynamic in nature. Unlike the traditional asset allocation funds that invest in debt and equity in a pre-defined proportion regardless of market conditions, the Dynamic Asset Allocation funds are the ones that allocate funds in equity, equity-linked derivatives and debt—based on pre-defined market indicators, mostly the Price-Earnings (PE) ratio.

Why should one choose Dynamic Asset Allocation Funds?

  • Dynamic Asset Allocation funds are safe and flexible but conservative. While they ensure some amount of returns as they book profits as the equity market rises and invest more in debt but at the same time, there is a fear of losing out on a sustained equity market rally, limiting the potential returns.
  • These funds are not meant for higher returns. These are chosen for the sake of stability and low risk.
  • While investing in Dynamic Asset Allocation Funds, one should have a time horizon of at least one year and ideally around 2-3 years.

How do these funds work?

It is rightly said that avoiding downturns is critical to long term success in investing. This remains the thumb rule behind investment in DAA funds.

Asset allocation is done by investing money in more than one asset with a prime objective of minimizing risk. The DAA funds sell equity during its upside and reinvest in debt / hedged derivatives. This way, the returns during a bull market remains lower but just after the end of the bull run, these funds tend to make maximum profits. Let us understand this with a simple example.

A fund has invested 40% of its funds in equities, 20% in debt, and 30% in equity-linked derivatives while keeping 10% as cash in hand. When the equity market peaks, the fund would reduce the equities portfolio to less than about 20% while increasing its exposure to debt/derivatives. Now when the equity market would slide, the fund would again increase its investment in equities while scaling down investments in debt.

Why is this done?

DAA funds’ investments are based on well-researched models of market behavior and are not driven by the fund manager’s whims. These funds try to achieve time-tested formula of “buying equities at lower levels and booking profits at higher levels.” So, the primary objective remains of earning superior returns while keeping the volatility low.

Dynamic Asset Allocation Funds and Taxation

What makes Dynamic Asset Allocation Funds even more attractive is their tax-free nature. Dividends from these funds and gains after one year are completely tax-free. Even short-term gains are taxed at 15%, which is lower than rate applicable on pure debt funds or bank deposits.

It can be safely said that DAA funds are apt for the ones with low risk appetite and longer time horizon. These funds can help you achieve better returns compared to bank deposits.