How does a Balanced Advantage Fund work?

Is the fear of market ups and downs keeping you from investing in equity markets? Dynamic Asset Allocation funds or Balanced Advantage Funds is a category of mutual funds that can help you here if you wish to invest in equity markets. 

Here’s all you need to know about Balanced Advantage Funds and how they work. 

What are Balanced Advantage Funds (BAF) or Dynamic Asset Allocation Funds (DAA)?

Balanced Advantage Funds or Dynamic Asset Allocation Funds are a category of hybrid mutual funds. This means that it can invest in equity, debt, and derivatives instruments. 

Balanced Advantage Fund aims to help investors create wealth while protecting them from the downsides.  

This category of hybrid funds is also exempt from SEBI exposure caps and minimum exposure requirements. Most fund houses have their in-house proprietary model for asset allocation strategy. So, a fund manager can invest in a mix of asset classes as per their view of the market.  

Components of BAF

Now that we know what a Balanced Advantage Fund is, let us look at the different components of the fund. 

Equity: These funds invest in equities, such as stocks, to help investors build wealth over the long term. Equity investments have the potential to generate inflation-beating returns, i.e. higher returns than inflation. 

Debt: Debt investments are less volatile than equity investments. Debt instruments help to reduce the overall risk of the fund and prevent losses during market downturns.

Equity Derivatives: Balanced advantage funds can also invest in arbitrage opportunities, i.e., the price difference in the spot and futures market. Derivatives are equity-related instruments but are relatively less risky than pure equity instruments.  

Working of a Balanced Advantage Fund

We have seen the different components that make up a balanced advantage fund. Now, we will see how these Balanced Advantage Funds work to generate reasonable returns for the investor. 

Buy Low-Sell High: 

Most balanced advantage funds aim to follow the disciplined ‘Buy Low and Sell High’ model. So, the fund manager can use a discretionary approach and sell stocks when the markets are high and buy stocks when the markets are trending lower.  

Dynamic Allocation between Debt & Equity:

Fund managers follow the Price to Earnings (PE) ratio to calculate if the markets are high or low. A high P/E ratio might indicate that a market is overpriced or that investors expect strong future growth rates. So, in this scenario, a fund house may look at decreasing their pure equity allocation.   

Fund houses like IDFC Mutual Fund have a PE band to determine their pure equity allocation. If the PE is less than 12, their equity allocation can be anywhere between 90 to 100% of the portfolio. 

Protect the downside risk: 

Balanced advantage funds have exposure to debt instruments and stock derivatives that help to hedge the fund’s losses during unfavourable market conditions. 

In-house proprietary model: 

Many fund houses have their own in-house proprietary models for balanced advantage funds. E.g., Nippon India Balanced Advantage Fund forms their core allocation by considering valuations, momentum, trade-weighted US Dollar and global demand indicators. Similarly, Edelweiss Balanced Advantage Fund uses their Edelweiss Equity Health Indicator (EEHI). The pro-cyclical approach of investing increases exposure on the winning side and lowers exposure to the losing side. 

Less risk of human biases:

Human biases may hurt the investment portfolio. As Balanced Advantage Funds follow a specific algorithm, whether PE ratio or their own in-house proprietary model, fund managers can reduce their human biases to a large extent. 

Equity taxation: 

As SEBI set no specific asset allocation for BAF, fund houses can fix their fund’s asset allocation mix. E.g., most fund houses aim to invest at least 65% of the fund’s portfolio in equity and equity-related instruments for the favourable equity taxation benefit. While their pure equity allocation can drop to 30% of their portfolio, funds maintain the minimum equity holding of 65% through equity derivatives. 

Conclusion 

Balanced advantage funds are a popular hybrid mutual fund category, as it uses a process-driven strategy to balance the fund’s portfolio between equity and debt. These funds invest more in equities when markets are rising and move to debt when markets are falling.

It can be an ideal mutual fund category for first-time mutual fund investors who want to create wealth but stay protected from market volatility.