What are Asset Allocation Funds?

Asset allocation funds are mutual funds that invest in a varied class of assets. These assets can be equity-oriented, debt-oriented or even other asset classes like gold, other metals, and commodities. This article covers the following:

Introduction

It is a balanced fund combining bonds and equities, that includes stocks, equity funds, bonds and real estate. The fund spreads the portfolio across more than one asset class, depending upon the investment mandate.There is a fund manager assigned who is tasked with keeping track of the investments and making necessary changes based on the performance in the market. In the case of mutual funds particularly, it is the fund manager who takes the asset allocation decisions. He develops an asset allocation strategy according to the investment objective of the fund. Each one of us wants to maximize our returns on investment.

By far, equities are considered to be the highest return generating asset class. However, equities also entail the highest degree of risk. On the contrary, bonds and money-market instruments like fixed deposits are low-risk but low-return investments. If you want to earn the highest returns, you may want to consider allocating all of your money to investments in equities. But that would also expose you to the risk of losing all your money.

Allocating the same investment across different asset classes, however, would earn you better returns by minimizing the risk. Deciding how much to invest in each asset class to achieve a risk-reward tradeoff is what is known as asset allocation.

Who should Invest in Asset Allocation Funds?

Asset allocation funds are meant for risk-averse investors. Equity is an important asset class to have because it helps beat inflation. But equity can also be volatile, which makes it unsuitable for all investors. This is where asset allocation funds come into the picture. Different asset allocation funds invest a part of their assets in equities and the rest in other assets. This helps them generate good returns while reducing risks. Balanced funds, for example, invest at least 65% in equities. Monthly Income Plans (MIP) invest 15% of their assets in equities. This is how different asset allocation funds can help earn higher returns without taking up too many risks.

Main Features of Asset Allocation Funds

The idea of asset allocation is to benefit from the appreciation of more than one asset as well as to reduce the risks that are associated with one particular asset.

Different Types of Asset Allocation Funds

Asset allocation funds can be broadly classified into two categories:

Dynamic Asset Allocation Funds

These funds keep changing/adjusting the proportion of assets in their portfolio according to the market fluctuations. When one particular asset class is expected to do well, the fund increases allocation to that asset and vice versa.

Static Asset Allocation Funds

Static asset allocation funds have a pre-decided percentage of funds allocated to different asset classes. The most popular type of funds here are balanced funds that invest at least 65% of their assets in equities and the rest primarily in debt.

Importance of asset allocation funds

Investors should consider asset allocation funds because of the following reasons:

Diversification

Investors who want to minimize their risk for a given time frame can invest in different classes of assets and diversify their portfolio.

Control over volatility

If an asset class performs outstandingly in one year, there is no certainty that it will perform equally well in the next year as well. The asset class can underperform as well. By investing in a diversified portfolio, your investments will not get affected greatly by one asset class.

Better returns

In asset allocation funds, the investor’s portfolio is exposed to numerous asset classes and therefore, it tends to enhance returns.

Taxation for asset allocation funds

Asset allocation funds are subject to taxation as debt funds as most of these funds are Fund of Funds. As per the investor’s tax slab, the short-term gains from debt funds are incorporated into the income and taxed accordingly.  There is a 20 percent taxation (adjusting the purchase price for inflation) with indexation, for long-term gains of 3 years and over. This lowers the tax burden due to lowered capital gains.

Factors affecting asset allocation decisions

The strategies for asset allocation depend on various factors that include – the age of the investor, their risk profile, financial goals, net worth and the prevailing market conditions. Additionally, asset allocation also varies depending on the investment horizon and the risk profile of the mutual fund scheme.

Fixed asset allocation strategy, also known as tactical asset allocation strategy, are those in which the mutual funds invest money in various asset classes based on a specific mathematical formula or a quantitative model. This model does not support those investors who have dynamic investment needs. There is certain other asset allocation determining models that are based on the Nifty 50’s price-to-earnings ratio that raise their debt allocation and avoid the pricey market. Taxes thus play a crucial role in the construction of a portfolio as both equity and debt have different tax structures.

Asset Allocation and the challenges in its execution

Tax Structure

The tax structure for different asset classes like equity and debt varies. Even in debt, there is a different tax structure for bonds, fixed deposits, and debt mutual funds.Thus, constructing a portfolio and balancing the taxation aspect becomes a challenge.

The Cost Involved

Some asset classes come at a very high cost. The fixed fee along with a performance incentive in the case of real estate funds or private equity is considerably high when compared to a simple mutual fund.

Monitoring of the Portfolio

 Monitoring of illiquid securities in your portfolio on a regular basis can be a challenge.

Size of the lot

When constructing a diversified portfolio in an asset class, the minimum investment requirement for a security may sometimes be too high.