The concept of dynamic fund is fairly recent in India. As a broad-based concept, dynamic funds are less than a decade old in India. Most investors are familiar with equity funds and debt funds, which have predominant allocations to specific asset classes. The concept of a balanced funds is also quite popular which mixes equity and debt in a certain proportion. A slightly more aggressive and active version of balanced funds is the dynamic fund. Like the balanced funds, dynamic funds also entail a mix of equity and debt, the only difference being that the mix is a lot more fluid and dynamic.
 
How dynamic funds stack up versus balanced funds..
A balanced fund is a fund that looks at a mix of debt and equity in its portfolio. This allocation mix is normally maintained at 65:45 in favour of equities as that will classify the fund as an equity fund and give it the special tax treatment that is given to equity funds. If the ratio of equity to debt falls below 65:45 on an average basis then for tax purposes that balanced fund will be classified as a debt fund. On the risk scale, balanced funds rank above debt funds but they rank below equity funds. In fact, balanced funds work fairly well in times when markets are volatile and non-directional as they combine the stability of debt and the alpha generation of equity to give a better overall product.
 
A dynamic fund, on the other hand, has a much wider canvas to shift its asset allocation. Theoretically, the dynamic fund can go from 0-100 % in equities and similarly it can also go from 0-100 % in debt. This decision will be based on the view of the fund manager. For example, if the fund manager feels that the market is undervalued in P/E terms then he may choose to substantially increase the equity component of the dynamic fund. Alternatively, if the fund manager feels that the interest rates are headed down, then the choice may be long duration debt, which will benefit the most in capital appreciation terms with every percentage point fall in the interest rates. The crux of the dynamic fund, therefore, is that there is substantial leeway to expand the allocation to equity and debt to its extremes.
 
Actually, dynamic funds are relevant at the current juncture..
Dynamic funds are very relevant in the current investment scenario. Firstly, both the equity and debt markets are currently in a state of flux. Equity markets are pondering a breakout provided it is supported by robust financials performance. At the same time, any slowdown in flows risks downsides in equity. On the debt front, the clarity on the US Fed trajectory and the recent cues from the MPC have created an element of uncertainty in the debt markets. It is uncertainty that gives fund managers the opportunity to stick their necks out and take a directional call on the allocation. That is where dynamic funds come in handy.
 
Secondly, the big challenge in equity investing is the trade-off between value and liquidity. It is essential to keep liquidity handy in the event of a correction and ensure that you are invested in the right stock at the right price at higher levels of the market. This can be automatically inserted as a discipline into investing by adopting the P/E approach to dynamic investing. It will substantially ensure that you are  liquid when markets are down and appropriately invested when the markets are making highs.
 
Lastly, dynamic funds permit you to get the best of equity and debt components. Hence it can be a boon for financial planners. Financial planning is all about rule-based discipline and a dynamic fund automatically infuses that discipline when you are planning to meet your long term financial goals. If property fine-tuned and marketed, dynamic funds can go a long way in assisting in the task of long term financial planning.
 
But, you also need to be aware of certain risks about dynamic funds..
Dynamic funds are not tax efficient in contrast to balanced funds. If the dynamic fund is not able to maintain an average exposure of 65 % to equities, it will be classified as a non-equity fund and hence will lose out the special benefits of an equity fund. Remember, equity funds get preferential treatment with respect to capital gains. In case of equity funds, long term capital gains (more than 1 year holding) is entirely tax free in the hands of the investor. Even short-term capital gains are taxed at a concessional tax rate of just 15 %, as against the peak tax rate in case of debt funds.
 
The dynamic fund defies simple definition and hence becomes difficult to benchmark and compare within the peer group. Even within the gamut of dynamic funds there is vast divergence in performance due to varying strategies and approaches adopted. There is also the question of which benchmark to adopt for measurement of performance as it would be hard to use a static benchmark for a dynamic asset allocation strategy.
 
Lastly, but not the least, there is the risk of fund manager bias in this product. A dynamic fund is essentially a function of the view and the perception of the fund manager. If the view goes wrong, it reflects on the performance. Additionally, as you change the dynamic allocations, there is the risk of transaction costs rising.
 
All in all, dynamic funds do offer a dynamic alternative. In a volatile market, it is surely an option to consider.