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Economic growth is influenced by a variety of factors including demographic forces and productivity growth. These factors can have different implications on monetary policies. Dynamic Asset Allocation Funds (DAAFs) aim to stay in sync with these changing factors. Interest rates are representative of the fundamental economic parameters of a country and can vary depending on the level of volatility in these fundamentals. For example, Zimbabwe’s central bank raised interest rates to 200% in June 2022 to prioritize economic stability.
Interest rates are a major factor that can affect the value of various asset classes, including equities. Higher interest rates can result in a higher opportunity cost and lower valuations. A dynamic asset allocation strategy should take into account interest rates as a key factor in decision making. Equity returns are also influenced by future earnings growth.
A dynamic band for equity allocation can help accommodate changes in interest rate scenarios. A higher price-to-earnings ratio (PE) at lower interest rates can be similar to a lower PE at higher interest rates. Due to the dynamic nature of the band, the same equity allocation can be made for scenarios when interest rates were low and the PE was high, as well as for scenarios when interest rates were high and the PE was low.
Interest rates, valuation and future earnings growth are all important factors that can affect asset allocation in DAAFs. Interest rates can influence the value of various asset classes and can affect the opportunity cost of investing in different assets. Valuation measures such as the price-to-earnings ratio (PE) can provide insight into the relative value of different assets and can help inform investment decisions. Future earnings growth can also be an important factor in determining the potential returns of different assets and can influence the allocation of assets within a fund.
DAAFs aim to take into account these and other factors when making investment decisions and allocating assets within the fund. By considering a combination of these factors, the fund can make informed decisions about which assets to invest in and how to allocate its resources to achieve its investment objectives.
Fundamentally, country’s strength, monetary policies and geopolitical issues are the key drivers of the financial markets. Fundamental parameters such as demography, fiscal deficit, forex reserve, inflation, trade deficit, geopolitical uncertainty etc. build fundamental economic framework of the country.
Thus, a combination of interest rates, valuation and future earnings growth should become an important parameter for determining the asset allocation in DAAFs.