Asset allocation is an essential risk management tool for any investor. It does that by diversifying the investment across various asset classes that don’t move together in any given market condition. For example, when equity gives a higher return, gold gives a poor return and vice versa.

However, for a newbie investor, practicing asset allocation may not be easy. She may not have the proper discipline to invest and rebalance the portfolio as per a given asset allocation. It is here that asset allocation funds come to the rescue.

Today, let us understand more about how asset allocation funds work and should you invest in them.

Understanding asset allocation funds

A typical mutual fund scheme invests pre-dominantly in a particular asset class. So, you have an equity mutual fund that invests in equity shares and you have a debt mutual funds that invests in debt products. However, asset allocation funds are a class apart. They have a mandate to invest across multiple asset classes like equity, debt, commodities etc. The asset allocation may be pre-fixed or dynamic depending on the investment objective of the fund.

Types of asset allocation funds

There are many different types of asset allocation funds available in the market. In 2017, SEBI took a big step to simplify the categorisation of mutual funds. However, for ease of understanding, these funds can be categorised in the following two buckets:

1. Static-allocation funds:

These funds have a clear pre-fixed range of allocation between asset classes. The fund manager cannot deviate from this allocation range. The fund manager periodically rebalances the portfolio to bring the allocation in line with the original allocation. The fund manager cannot take calls on allocation between asset classes. The best example is balanced funds, where the fund has to invest at a minimum of 65% in equity.

2. Dynamic Allocation funds:

Compared to static allocation funds, these funds have additional freedom to change the asset allocation depending on the market levels to achieve an optimal risk-return equation in any market situation. Mutual fund companies generally market them as balanced advantage funds. For example, suppose the equity markets are overheated. In that case, the fund manager can decide to reduce exposure to equity at 20% or even zero. As and when the equity markets correct significantly, she can raise allocation to 60% or 80% or even more.

Taxation of asset allocation funds

The taxation of these funds is not straightforward and depends on the equity allocation of the fund. If the fund generally has an equity exposure of above 65%, it will qualify as an equity fund. If not, it will qualify as a debt fund. The taxation can be understood with the help of the following table:
Type of fund for tax purposes  Short Term Capital Gain Long Term Capital Gain
Equity 15%  Exempt up to INR 1 lac per annum. Gain above that is taxable at 10%
Debt As per the investor’s tax slab 20%

Note: Above rates exclude applicable cess and surcharge. The holding period for qualifying long term capital gain is 12 months for equity and 36 months for debt funds.

What investor should look at before investing in these funds

The concept of asset allocation funds is a good one, especially in the context of new investors. This is because new investors lack the understanding and discipline to follow an asset allocation process. They may also not have developed the temperament to tide over the periodic waves of volatility that comes with investing in equity as an asset class.

However, asset allocation funds have not been able to post a decent performance record in India, with some exceptions. It is for this reason that investors should pay special attention to the following points before investing in these funds:

  • The asset allocation of the fund must be aligned to your financial goals. For example, suppose you have a goal coming up in next 5-7 years. In that case, you can choose a conservative hybrid fund. That fund will be predominantly debt-oriented with some equity exposure for that growth kick. However, suppose you make the mistake of selecting an aggressive hybrid fund. And the equity markets tank as the due date of your goal approaches. In that case, it can significantly derail your planning.
  • Take care to see that the fund manages debt side exposure appropriately and there are no lower-rated papers. The fund may expose itself to credit risk, proving very costly in recessionary market conditions.
  • Leaving broad asset allocation calls to the fund manager may be a good move on paper. Still, like other calls, it can backfire, impacting your returns. Here, the skill of the fund manager and the fund house’s investment philosophy plays a significant role.
  • You must check and clarify whether the fund qualifies for taxation as an equity or debt fund. This will save you from any tax penalties.

Our Verdict: Should you invest in asset allocation funds?

We feel that these funds may be a good choice if you are a first-time equity investor. This is especially so when markets are overheated. Over time, you should update yourself about asset allocation and portfolio rebalancing as you mature in your investing journey. This will help you take the call on asset allocation depending on your financial goal and not let it be outsourced to the fund manager. You can then invest in a mix of multiple schemes as per your asset allocation. Even if you decide to stick to these funds, we suggest that you prefer static asset allocation fund. The benefit in doing that is they can help you align your investment with your asset allocation in a better way.
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