Dynamic Mutual Funds – Concept, Management, Features, Benefits, Drawbacks & more

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Debt mutual funds invest predominantly in debt securities. Apart from earning stable income attached to the coupon rate of its securities, it also look to earn some amount of capital gain.

Fund managers achieve this by taking advantage of interest changes. Fund managers thus adopt a duration-based strategy. 

A fund type that actively adopts such a duration-based strategy is a ‘dynamic mutual fund’. In this article we look at the meaning of a dynamic mutual fund. 

We will understand how fund managers manage it as well as its key characteristics and benefits and drawbacks.

About Dynamic Mutual Funds

A dynamic mutual fund is a debt fund that follows a duration-based investment strategy. Duration is the maturity term of debt securities in the portfolio of the mutual fund. 

So, if a debt security matures within a year it has short duration. Whereas, if the debt security matures after 3 to 5 years, then it is of long duration. 

They invests in a combination of short, medium and long duration bonds.

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Management of Dynamic Mutual Funds

Fund managers  follow an active portfolio management strategy. This means that they are continuously monitoring and evaluating macro-economic factors that affect the portfolio.

Based on their analysis, they may constantly change to the holding in its portfolio so as to maximize returns for its investors. Dynamic mutual funds follow a duration-based approach.

This means that the fund managers frequently alter the duration of the bonds in its portfolio so as to take advantage of the external interest rate scenario. 

The rationale of this is that the market interest rate changes affect the value of debt securities significantly. 

When fund managers expect an increase in market interest rates, it will invest in short duration bonds. This is because lower coupon bonds will redeem in a short period. 

Fund managers re-invest these proceeds in higher coupon rate bonds. This can earn higher interest returns for the fund. 

On the other hand, when market interest rates might fall, fund managers invest in long duration bonds. 

As these bonds will have a higher coupon rate, their valuation will increase when market interest rates fall. Investors can thus earn capital appreciation on their fund investments.

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Features of Dynamic Mutual Funds

Here are major characteristics of Dynamic Mutual Funds –

Flexibility in fund portfolio

Unlike specific duration funds, dynamic funds have the flexibility to invest across durations.

They can invest in short duration funds in a risking interest rate scenario and in long duration funds in a falling interest rate scenario. 

Fund managers are thus not bound to invest in bonds of any specific duration. They can invest in whichever debt securities in which they see a profitable opportunity.

Nature of returns

Dynamic mutual funds like debt mutual funds look to earn stable and regular income for its investors. This is linked to the coupon rates of the debt securities that it holds in its portfolio. 

They also however seek to earn capital growth for its investors. By tweaking its investment strategy in response to anticipated interest rate changes, it seeks to maximize the value of its holdings.

 In this way investors can also earn capital gains from its investments in dynamic funds.

This strategy of dynamic mutual funds can make it earn higher return than specific duration funds that are bound to invest in bonds of fixed duration. 

They are however likely to earn lower returns than market linked funds such as equity-based funds.

Risk susceptibility of dynamic mutual funds

Dynamic mutual funds are subject to similar risks that debt mutual funds are subject to:

Credit risk – The risk that bonds will not be honored for either interest or principal.

Interest risk – The risk of adverse changes in valuation of the fund’s holdings due to volatility in interest rate.

Liquidity risk – The risk that the fund house will not have enough liquidity to service redemption requests from its investors.

In addition to the above, dynamic mutual funds also have additional risk owing to its active portfolio management approach. 

This is the risk arising on account of the expertise and judgement of the fund manager.

In case the fund manager is unable to respond to market changes in a timely manner or mis-predicts interest rate movements, the fund’s value can be adversely impacted.

Additionally, such funds also are at a risk of non-predictability of several macro-economic factors. These factors have a bearing on interest rate movements. 

As interest rate is at the core of this fund’s strategy, adverse changes in these factors can have a negative effect on the fund performance. 

Taxation on redemption

Dynamic mutual funds are taxed in the same way as standard debt mutual funds are taxed. If they are held for less than 3 years, gain on their redemption is taxed as short-term capital gains. 

This is taxed at the slab rate applicable to the investors. If the units of this fund are held for more than 3 years, the gain is taxed as long-term capital gains.

This is taxed at 20% after the benefit of indexation. As is the case with other debt mutual funds, there are no TDS implications on redemption proceeds.

Suitable investors for Dynamic Mutual Funds

Dynamic mutual funds are sought out for higher returns with slightly higher risk than fixed duration mutual funds. They are suitable for the following investors: 

• Dynamic funds have an ideal investment horizon of 3 to 5 years. This is the time period within which the fund can give returns. This makes them suitable for investors who are saving money for medium term goals.
• Keeping a shorter time frame can increase the risk level of this fund as well as earn lower returns for the investors. This is because fund managers are unlikely to earn high enough returns in a short term as interest rate changes may be marginal.
• Investors seeking better returns than fixed duration mutual funds at slightly higher risks can opt for these funds.

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Evaluation of Dynamic Mutual Funds

Investors should evaluate certain factors before deciding which dynamic mutual fund to invest in:

Fund Manager Expertise

The performance of dynamic mutual funds is greatly dependent on the expertise of the fund manager.

The fund manager must have the experience and judgement to track and predict interest rate movements. 

He must also be pro-active in his approach to make quick changes in the portfolio in response to interest rate changes. 

An inexperienced fund manager may be unable to take advantage of possible interest rate changes and may lose out on capital growth opportunities. 

This can adversely impact the fund performance. Thus, assessing the expertise of the fund manager is important whilst choosing a dynamic fund.

Expense ratio

The annual fee charged by fund houses for management of the funds is termed as expense ratio. The higher the expense ratio, the lower the returns available for distribution to investors. 

Thus, investors should evaluate dynamic funds on the basis of their expense ratio. Investors should prefer lower expense ratios to maximize investor return.

Investment horizon

Dynamic mutual funds are likely to perform best over a medium to long term duration of 3 to 5 years.

Fund managers require this time frame so as to have enough time to generate sufficient capital growth opportunities from the market. 

Thus, investors should evaluate their investment objectives and choose dynamic funds for those needs that will arise after 3 to 5 years.

Benefits of investing in Dynamic Mutual Funds

Here are the list of benefits of investing in Dynamic Mutual Funds –

Better returns in the form of capital growth

Dynamic mutual funds are likely to earn higher returns than fixed duration funds as well as that of liquid or overnight funds. The higher returns are likely to be in the form of capital growth.

The portfolio values can increase if fund managers make timely changes in the portfolio holdings based on the changes in the market interest rates.

Flexibility

These funds do not bind its fund managers with any specific mandate to invest in bonds of a specific duration. They can adjust the portfolio in response to market changes.

As they are not bound by any specific duration-based requirements, they may be able to generate more profit-making opportunities than other debt funds.

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Drawbacks of investing in Dynamic Mutual Funds

Here are the list of disadvantages of investing in Dynamic Mutual Funds –

Over-dependency on fund manager expertise

The performance of dynamic mutual funds is highly dependant on fund manager expertise. 

Only if fund managers make correct judgement calls and investing decisions will the mutual fund perform well and earn capital growth for its investors. 

Such over-dependency on the expertise of the fund manager increases the risk that these mutual funds are susceptible to.

Risk of macro-economic factors

Dynamic mutual funds rely on interest rate changes for capital appreciation. Interest rates typically change in response to several macro-economic factors. 

Changes in these factors are what drive the government to make changes to interest rate. 

Macro-economic factors however can be unpredictable and not in the control of fund houses or their managers. This thus increases the risk factor for dynamic funds.

Dynamic Mutual Funds – Conclusion

Dynamic mutual funds are thus a good investment type to earn investors both regular income as well as additional income in the form of capital growth. 

Investors that are not satisfied with the growth levels of conventional debt mutual funds can look additional growth in the form of capital appreciation by investing in dynamic mutual funds. 

This of course is at a slightly higher risk.

Thus, investors must also be ready to take on this additional risk and to hold on to their investments for at least 3 to 5 years before they can begin to reap benefits.

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