Dynamic Mutual Funds

Types of Dynamic Mutual Funds

The term dynamic mutual fund does not refer to a formally defined regulatory category. Rather, the term is used to describe funds which regularly modify their allocation of assets in reaction to fluctuations in the market. As is commonly understood, there are two primary ways strategies can be applied:

Dynamic Equity Funds

• Dynamic equity funds tend to be focused on equities and have the flexibility of choosing the amount of exposure to equities.

• They will change the percentage of equities to cash (or hedging instruments) based on current valuations for equities, other indicators about the economy, and current assessments of risk.

For example: If current valuations for equities seem to be highly valued/volatile and not the right place to invest, the fund will have lower equity exposure and a higher percentage of cash or hedging instruments.

Conversely, if the conditions are right to earn returns from equity investments, the fund will increase its percentage of exposure to equities in order to take advantage of that opportunity.

From a portfolio standpoint, the fund is primarily investing in equities. In other words, dynamic equity funds will continuously adjust the ratio/percentage of equity to cash based on an equity investment framework, while also managing risks and maintaining exposure to potential future returns.

Dynamic Asset Allocation Funds

• Dynamic asset allocation funds utilize a wider and more adaptive method of investing by allocating investments across various asset categories.

• Dynamic Asset Allocation funds are a type of investment fund that invests in stocks (equity), fixed income securities (debt), short term financial instruments (money market), and some instances of derivatives.

• When the stock market appears to be at a good price, the fund will usually increase its allocation to stocks.

When the stock market is being viewed as overpriced or risky, the fund will generally increase its allocation to fixed income or another type of less risky security. The amount allocated to a given asset type can vary drastically, depending on the fund's investment model and mandate.

So, dynamic asset allocation funds do not simply readjust their stock allocations; dynamic asset allocation funds make adjustments across all asset types for the purpose of controlling risk and maximizing the returns over the life cycle of the market.

Features of Dynamic Mutual Funds

The following table discusses the features of Dynamic Mutual Funds:

How is a dynamic mutual fund different from a balanced mutual fund?

Many investors tend to confuse dynamic mutual funds with balanced funds which also invest in a mix of debt and equity securities. However, both of these funds differ in many aspects and the differences are as follows:

Benefits of Investing in Dynamic Mutual Funds

As stated above, dynamic mutual funds can even out the fluctuations in the capital markets to deliver attractive returns to the investor. The other benefits that dynamic mutual funds offer have been listed below:

• Dynamic Mutual Funds: They change how they invest in stocks (i.e., equity) and bonds (i.e., debt) based on the value of each type of investment in the market and the state of the economy. They try to reduce stock investments in periods when the economy is not as strong and increase stock investments in periods when the economy is doing well, to limit the range of returns and create a smoother return profile over time.

• Professional management of mutual funds: Professional fund managers are responsible for monitoring interest rates, inflation, earnings and economic activity so that investors can take advantage of market information without having to track what is happening in the market.

• Potential for improved adjusted return for risk: These funds do not only try to get maximum returns. They also want to control risk while they try to get maximum returns. The way they try to control risk is to move money into and out of different investments, taking advantage of the progress in the economy while trying to protect against the declines in the economy.

• Flexibility to adapt to changing market cycle conditions: Dynamic funds can have a large range of exposure to stock and bond investments, unlike fixed allocation funds, so the funds can easily adapt to a new investment climate from one cycle to another.

• Long-term investor suitability: The balance between risk and reward makes these funds an attractive choice to long-term investors looking for steady growth in their investment with limited volatility.

• Tax treatment: The tax treatment of dynamic mutual funds will be based on the amount invested in stocks for the particular fund and on the laws that apply to the classification of the fund. There are some possible opportunities for tax savings depending on their classification and length of time invested right now.

How Do Dynamic Bond Mutual Funds Work?

Dynamic Bond Mutual Funds are modified and actively managed funds that seek to leverage changes in interest rates. Below are the processes involved:

• Step 1: Analyzing the Economic Environment

Fund Managers will analyze the macro economy using indicators like inflation, money supply, and economic performance. This analysis will allow the Fund Manager to determine whether interest rates will rise, fall, or remain unchanged.

• Step 2:  Adjusting Portfolio Duration

If the economic analysis suggests interest rates are going lower, the Fund Manager increases exposure to longer maturities (long-term Bonds); since long-term securities will appreciate significantly when interest rates decline and the potential for capital gains will exist.

Alternatively, if the analysis suggests that interest rates are increasing, the fund manager will begin to reduce exposure to longer-maturity (Long-term Bonds) and increase exposure to shorter-maturity (Short-term Bonds) so that capital losses from the interest rate increase can be minimized.

• Step 3: Selecting Securities

Within the portfolio of the Dynamic Bond Mutual Fund, securities will either be Government Bonds or Corporate Bonds. Government Bonds typically offer more security than corporate bonds. Therefore, if the economic conditions are uncertain, there is a tendency to prefer to invest in Government Bonds. 

Conversely, when the Credit markets are stable, Corporate Bonds can provide greater yields than Government Bonds.

• Step 4: Continuous Monitoring and Rebalancing of the Portfolio

The investment portfolio will be assessed periodically, based on any changes in market circumstances.

Dynamic Bond Mutual Funds seek to maximize return through an active strategy of managing duration and credit. Returns from dynamic funds are linked to the performance of the underlying securities and therefore cannot be guaranteed.

Best Ways to Invest in a Dynamic Bond Mutual Fund

Investing in dynamic bond mutual funds can be very easy and also very convenient. You may use the online site for your Asset Management Company (AMC) to invest directly, or you may use an online investment platform that works with a registered AMC. It is important to make sure your KYC requirements are met before you invest

From there, there are basically two different ways in which you can invest:

• Lump-sum investment: You put a large amount of money into the fund in one shot. This is more appropriate if you have extra money and have a clear idea of where interest rates are headed.

• Systematic investment plan (SIP): You invest a fixed amount of money at regular intervals over time. This reduces timing risk and makes investing more disciplined.

Finally, before you invest, evaluate your investment objectives, your level of risk tolerance and your expected investment time frame to determine if dynamic bond mutual funds fit into your overall investment portfolio.

Reasons to Invest in Dynamic Bond Funds

Investors looking for an active management approach to their fixed-income investments should consider dynamic bond funds. Some of the benefits of investing in these types of funds are outlined below:

• Active Management Approach

Dynamic bond funds have an active management style where the fund manager continuously rebalances the portfolio by moving between short-term and long-term fixed-income securities based on their expectations for future interest rates.

As a result of this flexibility, the fund can benefit from declining interest rate environments by taking advantage of increased capital appreciation from long-term bonds. The fund's total return may experience short-term fluctuations due to changes in bond prices and other market conditions.

• Improved Interest Rate Sensitivity

Dynamic bond funds do not have a predefined maturity profile unlike fixed-maturity fixed-income funds. As a result, a dynamic bond fund can adapt to the current economic environment and potentially reduce their sensitivity to increasing interest rates.

• Lower Volatility than Long-Term Fixed-Income Funds

Dynamic bond funds are generally much less volatile than long-term fixed-income funds because the portfolio duration is continuously being managed. By managing their exposure to long-term bonds when interest rates are rising, the fund seeks to minimize potential capital losses.

Taxation of Dynamic Bond Funds

Dynamic bond funds are taxed like all other debt mutual funds, following the current taxation legislation.  The indexation process takes inflation into account when determining the cost of an investment. Therefore, in some instances, the application of the indexation process results in a lower amount of taxable gain from redeeming the units in a dynamic bond fund.

Thus, ultimately providing the investor with a higher net return after considering the amount of tax paid. It is critical that the investor considers the applicable taxation laws at the time of making an investment decision.

• The gains from an investment in a dynamic bond fund that are realised through redemption of the units within three years will be treated as short-term capital gains (STCG) and will be taxed under the investor's rate of income tax.

•  Should the units be redeemed after three years, the gains will be treated as long-term capital gains (LTCG) and taxed at 20% plus indexation.