Although these funds contain market volatility better than others, they also give lower returns over time.

Equity investors pour more money into the markets when they are going up and stay away during downturns, which can hurt returns. To protect investors from such behavioural bias, there is a category of mutual funds called dynamic equity funds. As the name suggests, these funds dynamically manage their equity portfolios, investing more when markets are down and less when they are up. But are they useful?

Understanding dynamic funds

There are two categories to consider in this context: dynamic asset allocation funds and dynamic equity funds. The former usually have more flexibility to take extreme calls across asset classes. They may even go 100% in on an asset class, based on their strategy. They may also have sub-categories such as aggressive, moderate or conservative, and be an equity or debt-oriented fund accordingly. Some funds in this category also follow the fund of funds structure, whereby the fund invests in other equity and debt funds.

Dynamic equity funds, on the other hand, are largely equity-oriented, and tweak their exposure to equity and cash based on market valuations and other metrics. For instance, Axis Mutual Fund has launched a new fund offer in this category called Axis Dynamic Equity Fund. Based on market valuation, trend and risk, the fund's equity allocation can be in the range of 30-100%. Given the current readings, the recommendation would be a net equity exposure of 50%.  However, the fund will look to maintain a minimum of 65% in gross equity. Any net exposure reduction below that will be achieved through hedging using derivatives.

When does it work?

As dynamic equity funds tweak their exposure based on market levels, they may contain volatility better than diversified equity funds, which are fully invested across market levels and phases. By reducing equity exposure and increasing cash allocation at appropriate market levels, these funds ensure downside protection.

The lower volatility of these funds is also evident in their standard deviation (SD), which measures volatility in a fund's return.The lower the SD, the less volatile the returns. Their 3-year category average SD is 10.32%, compared to 14.18% for diversified equity funds (see table). But it is higher than that of dynamic asset allocation funds.

When does it fail?

While the volatility of returns in these funds is lower than that in diversified funds, the returns are also lower. Dynamic equity funds have underperformed compared to diversified equity funds over time, as they also tend to time the market. The 5-year category average returns are at 14.57%, whereas that of diversified equity funds is 18.39%.

Further, dynamic equity funds tend to hold higher cash in prolonged rallies and can, therefore, underperform in long upmarket cycles. These funds may underperform during strong market conditions. To get the best out of dynamic equity funds, it is important to invest over a 3-5-year cycle.

Should you opt for it?

It is not easy for a small retail investor to understand the different models and variables used by dynamic equity funds to determine the asset allocation. Investors would be better off doing their own asset allocation at an individual portfolio level. Bala concurs, Asset-allocated portfolios can do a good job if investors look at the performance at a portfolio level instead of looking at individual fund volatility. Dynamic equity funds may be suitable for those who are very conscious of market valuations and are wary of over-valued markets. But diversified equity funds are a better bet, since they are simple to understand and offer higher returns over time.