All of us understand the red (stop), yellow (pause) and green (go) signals of a traffic light. What if there was a similar mechanism that allowed us to take the right investment decisions especially those related to increasing or decreasing equity market exposure without worrying much about volatility and market valuations.
It’s all about Greed and Fear
Human behavior whether in life or investments is ruled by two powerful emotions – Greed and Fear. The influence of these emotions often leads to irrational decisions. ‘Buy low and sell high’ is the most common equity investing thumb rule we all know. But knowing does not mean following. Most of us do exactly the opposite - we buy more when markets rise and sell when markets fall. That’s because, perfect market timing requires the right exit and re-entry point which is seldom possible. Getting even one of these wrong can significantly affect investor returns.
What we need is a balanced and emotion-free mechanism that allows us to take the right investment decisions. Here is an approach offered by mutual funds to do exactly this. Welcome to the world of Dynamic Asset Allocation Funds (DAAF) which have an in-built traffic lights type of mechanism to buy and sell rationally by being agnostic to the emotions of greed and fear. Let’s understand this a little more in detail.
Best of both worlds
DAAF are hybrid funds investing predominantly in equity and debt which help to manage equity volatility better through diversification. What makes them different from other hybrid funds is their dynamic asset allocation strategy (most hybrid funds follow a static/ fixed asset allocation strategy). As the name suggests, they change their allocation to equities dynamically depending on market conditions. While the equity component aims to maximize returns, the debt component strives to provide stability and cushions the downside risk of the equity component. The combination thus has the potential to generate higher risk-adjusted returns.
The specialty of DAAF is a mathematical model consisting of valuation parameters like price-to-earnings (PE) ratio, price-to-book (PB) ratio, etc., which helps to automatically increase equity allocation when markets are cheap and decrease it when they are expensive. For example, the allocation to equities would rise with a lower PE or PB and vice versa.
About Franklin India Dynamic Asset Allocation Fund of Funds (FIDAAF)
FIDAAF is a 16-year old fund of fund which invests in a dynamically balanced portfolio of equity and debt funds of Franklin Templeton Mutual Fund. The fund has been repositioned from the erstwhile Franklin Templeton India Dynamic PE Ratio Fund of Funds (FIDPEF) by making a few changes in its structure to account for the growth of the Indian capital market (especially the small & midcap segment) in the past 16 years besides improving the robustness of the asset allocation strategy.
The fund’s structure:
The fund has undergone the following key fundamental attribute changes :
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FIDPEF |
FIDAAF |
Value-addition |
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Primary Equity fund: Franklin India Bluechip Fund (FIBCF) Secondary Equity fund: Franklin India Equity Fund (FIEF) |
Primary Equity fund: Franklin India Equity Fund (FIEF) Secondary Equity fund: Franklin India Bluechip Fund (FIBCF) |
FIEF being a multicap fund will provide exposure across market cap. FIBCF is a large-cap oriented fund and restricts FIDPEF's access to mid and small cap equity. |
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Secondary Fixed Income fund: Franklin India Income Opportunities Fund (FIIOF) |
Secondary Fixed Income fund: Franklin India Low Duration Fund (FILDF) |
Duration profile of FILDF is closer to the primary fixed income fund (Franklin India Short Term Income Plan-FISTIP). |
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Index to determine asset allocation: Nifty 50 Index |
Index to determine asset allocation: Nifty 500 Index |
Change in primary equity fund will trigger a change in the index to gauge equity valuation |
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Equity allocation using PE ratio of NSE 50 Index |
Equity allocation using a combination of PE ratio and PB ratio of NSE 500 Index |
Rigorous back-testing indicates better outcome by combining PB & PE. |
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Equity allocation range: 0-100% |
Equity allocation range: 20% - 85% |
Summing up
FIDAAF is for investors looking for a balanced exposure to equity and debt over the longer term while also capitalizing on opportunities provided by the market from time to time. Apart from the benefits of diversification, this formula driven approach with its in-built ‘buy-sell’ discipline helps to negate the behavioral biases caused due to emotions of greed and fear. In short, FIDAAF aims to maximize returns by minimizing risk over the long run. “Be fearful when others are greedy and greedy when others are fearful” – that’s FIDAAF embedded in this famous Warren Buffet quote!!
