These funds are touted as having the best of both worlds- they cushion the portfolio against the downsides, yet are able to benefit from the upsides. This week our cover story examines whether BAF can deliver on that promise. We also look at how much depends on the allocation model governing individual funds and whether these funds should find a place in your portfolio.
too many promises
BAFs dynamically adjust allocation to equity and loan of according to market conditions. But there are wide variations in how they do so. Some funds shift the equity allocation within a band of 30-80%. Others have the flexibility to keep the equity allocation from zero to 100%.
Apart from asset allocation calls, BAFs also actively hedge their equity positions, which further helps limit losses during downturns. When market conditions pose a low risk in equities, funds may largely place derivatives or arbitrage bets in place to artificially reduce equity allocation. The adjusted net-equity exposure for hedge positions is very low in such cases, even if the fund’s total equity exposure remains above 65%. This is important in order to enjoy the tax benefits passed on to equity funds (long-term capital gains up to Rs 1 lakh are tax free, and above that are taxed at 10%, while short-term gains are taxed at 15%) . In July, the DSP Dynamic Asset Allocation Fund was sitting at 66% gross equity allocation, but had hedged 25% of the portfolio, so its net equity exposure was less than 41%.
singing different tunes
The most important aspect of BAFs is how their asset allocation calls are triggered. This change is usually guided by the fund house’s internal model and may be governed by very different rules. Swaroop Mohanty, CEO, Mirae Asset Global Investments, said, “Not all BAFs are the same. This is perhaps the only category that has vastly different offerings.” For some funds, valuations are triggers to move money in or out of equities. They increase exposure to bonds when stocks are expensive and vice versa, which translates into a counter-cyclical approach of buying low and selling high.
“Counter-cyclical BAFs operate on the premise that the market eventually returns to the average,” said Anish Teli, founder of QED Capital. Funds rely on metrics such as price to earnings (PE), price to book value (PBV), earnings yield or a combination of several such metrics to guide asset allocation. Aditya Birla SL Balanced Advantage Fund and PGIM India Balanced Advantage rely on PE multiple to guide the asset mix
Balanced Advantage goes by PBV. Some, such as L&T Balanced Advantage and the new offering Franklin India Balanced Advantage, use a combination of PE and PBV in their models. Others follow a pro-cyclical or trend-driven approach, which goes with the trend of the market and not against it.
They go with high equity allocation in rising market and low in falling market. DSP Dynamic Asset Allocation Fund, Kotak Balanced Advantage Fund and Nippon India Balanced Advantage Fund offer a mix of valuation and trend indicators. Balanced Advantage operates a pure trend-based model that uses a combination of momentum and volatility factors as the main indicators to identify a market trend and its stability.
until recently,
Balanced Advantage retained approximately 70% of its exposure to equities, but now follows a more dynamic model in line with peers. BAFs also follow different strategies within equity and bond portfolios. Some invest mostly in frontline stocks while others have a good presence in the broader markets. Within bonds, some funds take active-duration calls (switching between long- and short-term bonds) or run a high-yield credit strategy (bonds with low credit quality), while others go for higher-grade bonds and accrue on Let’s focus.
These variations in investment strategies are reflected in the disparate risk profile of the BAF (
see table) With different asset allocation models, these differences can lead to different outcomes. Moreover, this category was created only in 2018. Funds in this category are either parachuted out of a separate category or are erstwhile balanced funds that are also involved in derivatives. Therefore, many BAFs in their current form have a limited track record, which hinders meaningful analysis of their performance.
finding the right mix
Are the asset allocation models of these BAFs functioning properly? Not always, the short answer is. “These models are not as agile as they are believed and can be caught on the wrong side,” says Santosh Joseph, founder, Germinate Investor Services. The limits of valuation-based triggers are most evident in counter-cyclical models during sharp market volatility. Ashutosh Bhargava, fund manager and head-equity research, Nippon India Mutual Fund, explains, “A completely valuation-based allocation model will not work when the market cuts or rebounds are very sharp and sharp.”
For example, during the March 2020 crash, several funds were misappropriated. As stock prices declined, the index valuation multiple shrank, prompting valuation-centric models to increase equity exposure to an upper limit. But as the markets fell further, the rise in equities hurt these funds.
Funds that depend on market trends on valuation are also not infallible. They work best when the market trend is clear. During the March 2020 sell-off, Edelweiss BAF held a modest 35% equity exposure, while other funds increased allocation to shares. This protected the fund from 60% of the 38% slide in the Nifty. Later, as the market momentum shifted positively, the model increased equity exposure and allowed the fund to capture the upside.
But this pro-cyclical or trend-based model has limited utility in the sideways market. Between October 2021 and July 2022, the market remained deserted. Edelweiss BAF eased Nifty’s 26% fall. However, history shows that such non-trending market conditions do not continue for long. Furthermore, models should be judged on the basis of how they perform in a market cycle, not at specific stages.
Not every AMC clearly spells out the intricacies of its model, which makes it difficult to get a clear understanding of the fund’s workings. Often, the model is proven to work wonders in back-tested data, but results can vary greatly in real time. “It can be difficult to execute the model consistently at large sizes,” Teli said.
don’t get caught up in the hype
Some assumptions about BAF should be dispelled. They are not necessarily all-season funds. A major fund house declared that with BAF, “the investor wins no matter which direction the market moves”. this is not right. While the debt portion in such a fund will limit the downside during market downturns, the fund is not completely protected from losses. “The objective of these funds is purely to hedge against losses and not keep pace with the market,” Mohanty insists. Even though some BAFs specialize in reducing losses, not all funds can do so equally.
In the past, BAF has been unfairly sold as a source of regular income through SWP. The SWP facility was further promoted as a secure monthly income option. SWPs work best when withdrawing from funds with low volatility. BAFs may have less volatility than pure equity schemes, but they are not suitable for regular withdrawals for income. On an average, these funds posted a 6-month loss of 24% over the past three years. Therefore, SWPs from BAFs carry the risk of redeeming them at a loss, while the source fund depreciates in value. In contrast, only one ultra-short duration fund and no liquid fund made 6 months loss. “The BAF on volatility during market extremes is not necessary,” said Praleen Bajpai, Founder, Finfix Research & Analytics.
Secondly, a BAF doesn’t really solve your asset allocation problems. Anyone suggesting otherwise is making a wrong sale. “The manner in which these funds are sold is a matter of concern,” admits Mohanty. For any fund to qualify as an asset allocation solution, you need to invest the entire amount in that scheme so that the fund covers your entire asset allocation. Even if not investing in any other mutual fund, individuals may have other investments. How can a fund manage the asset allocation of the entire portfolio? Furthermore, asset allocation is not a one-size-fits-all concept. Different risk profiles may differ, guaranteeing different asset mixes that cannot be decided by a single fund.
Who are BAFs Ideal for?
Essentially, these are risk-mitigation products designed to limit volatility and are only suitable for certain investors. Mohanty stressed, “BAF can be useful for conservative investors who want to move up the risk ladder. Growth assets without any risk will increase the returns in the portfolio. Also, investors with high equity exposure can invest in BAFs to reduce portfolio volatility. “These funds can help ease the journey of equity investors,” says Bajpai. Investors who panic during times of high volatility can also find comfort in these funds. But savvy investors can avoid them because the BAF limits the extractable value from the market, argues Joseph.
The real usefulness of BAFs lies in how they handle the sentiments of an investor. When markets are volatile, investors often exit out of fear. They return when prices have already risen, only to be disappointed when the market drops again. Others drop out too quickly, missing the opportunity to build wealth. By limiting drawdown, a BAF prevents an investor from making emotional mistakes. Staying invested is what ultimately facilitates meaningful wealth creation. Radhika Gupta, CEO, Edelweiss AMC said, “Is BAF right? No, it is not a chocolate cake, and it does not please everyone. But it is a good dal rice and gives good returns without much loss. Good enough for many investors.”
How to choose the right BAF
Choosing a fund on the basis of returns will defeat the very purpose of investing in BAF. These funds are meant to reduce volatility while ensuring good bounce. They are not ready to give high returns in the long term. So, the best fund may not be the one with the highest returns. If returns are a priority, choose pure equity funds. Downside protection should be emphasized. “Choose a fund based on its performance during the recession.
A fund with less downside as compared to the market is apt to give some relaxation in bad times,” says Bajpai. Also, the fund should be able to offer healthy participation in the market upwards. Funds like DSP Dynamic Asset Allocation, Edelweiss BAF, ICICI Prudential BAF,
The BAF and the Union BAF have demonstrated these qualities in the past. Choose from funds whose allocation model has been time-tested. Since these largely take rules-based calls on asset allocation, the track record can be an indicator of its future behavior. And, as always, avoid new unutilized funds or NFOs.