While both balanced and dynamic funds follow an asset allocation approach -- investing in debt and equity based on market conditions--they differ in their approach to juggling the asset mix. While balanced funds maintain a steady exposure to equity and debt, dynamic asset allocation funds switch aggressively. They can invest between zero and 100% in equity, depending on the market situation. The degree of flexibility is much wider in dynamic asset allocation. Balanced funds typically invest at least 65% of their corpus in equity, and the rest in debt. The equity portion varies between 65% and 75%.

The good and the bad

While both the categories attempt to contain volatility in returns, dynamic asset allocation funds score over balanced funds in this respect. Across different time frames, they have exhibited a lower standard deviation (around 0.4%)--a measure of volatility in a fund's return. So, even though balanced funds have delivered better returns over longer time frames, these have come at a slightly higher risk--standard deviation of over 0.7%--compared to dynamic funds.

What also works in favour of dynamic funds is they do away with the need to actively monitor and rebalance the portfolio. With rising equity market valuations, these funds will invest a larger portion of the corpus in debt and cash while cutting down on equities. Declining market valuations will automatically trigger ramp up in allocation to equities while slashing exposure to debt. Dynamic funds are beneficial to those who do not have the stomach for timing the market.Since the fund does the rebalancing automatically, they do not have to worry about where to put their money.

Dynamic asset allocation funds, however, fall short on tax efficiency. Equity-oriented balanced funds typically maintain a 65% exposure to equities, and qualify for better tax treatment compared with dynamic funds. Gains realised after one year are tax-free for the investor, even the debt portion incurs no tax. However, most dynamic asset allocation funds follow the Fund of Funds structure--where the fund invests in other equity and debt funds--so are taxed as non-equity funds, irrespective of their level of exposure to equities. For other schemes, which invest directly in stocks and bonds, the taxation depends on the average level of exposure to equities during the year. If at the time of exiting the scheme, it has maintained, on an average, 65% of its corpus in equities for that particular year, the scheme is treated as an equity fund for taxation purpose. Otherwise, any realised gains are taxed along the lines of a debt fund, making the scheme tax inefficient.

Another problem with dynamic funds is that their investing models are not alike. The different approaches may be difficult to understand. While most switch between equity and debt, based on the relative valuation of the two segments, they use different metrics to gauge the extent to which markets are underor over-valued. For instance, Franklin India Dynamic PE Ratio and Principal Smart Equity decides allocation based on the PE multiple of the underlying index, ICICI Prudential Dynamic Fund goes by the Nifty's price-to-book value and DSP BlackRock Dynamic Asset Allocation Fund considers the 10-year government bond yield over earn ings yield of the Nifty.

Dynamic Funds or Balanced Funds

Given their flexible structure, dynamic asset allocation funds should be best suited to capture market opportunities, but the aggressive rebalancing sometimes acts as a handicap for the funds as they cannot capture the market upside effectively. That is why experts say balanced funds are a better choice for managing risk for most investors. Investors would be better off with a flexible allocation within a narrower band with a plain vanilla balanced fund