Valuation swell prompts large balanced advantage funds to lower sails

Adjusting to market tides: Large BAFs trim net exposure to below 60%

The net equity exposure of most large balanced advantage funds (BAFs) has decreased in the past few months, with two of the largest schemes in this category offered by ICICI Prudential Mutual Fund (MF) and SBI MF lowering allocations below 40 per cent.

The average equity exposure of the five largest schemes stood at 53.4 per cent at the beginning of the calendar year 2024 (CY24). It decreased to 51 per cent by the end of April 2024, according to portfolio disclosures.

BAFs manage equity and debt allocation dynamically, depending on underlying valuations. Although regulations provide complete flexibility to such schemes regarding allocations, they typically opt for a minimum 65 per cent equity exposure to benefit from the equity tax treatment, which is advantageous compared to debt.

However, BAFs use equity derivatives to reduce their net exposure to below 65 per cent while complying with the taxation requirement at the gross level.

The Edelweiss BAF, which follows a pro-cyclical asset allocation model as opposed to the more common countercyclical approach, is the only fund among the top eight to have over 60 per cent exposure to equities.

Other schemes also differ in terms of the asset allocation model and the internal limits on maximum and minimum exposure to equity and debt.

For example, ICICI Prudential BAF’s model is built around the price-to-book ratio rather than the more common valuation metric of price-to-earnings (P/E). Tata MF uses the average of trailing and forward P/E to determine the equity allocation.

“Valuation is the crucial metric in our model, as it takes the average of trailing and forward P/E into account. Momentum and technical factors also have some weight. Based on these metrics, we get a combined score, which is used to decide the optimal exposure to equities,” said Rahul Singh, chief investment officer-equities, Tata Asset Management.

Valuations have been in focus for the past few months after the equity market rally picked up pace in November 2023.

The P/E ratio of key benchmark indices had exceeded the long-term averages at the start of CY24 as the 12-month trailing P/E of the National Stock Exchange Nifty 50 and S&P BSE Sensex rose to around 25x. The ratio has since decreased and is now around 22x.

Valuation concerns were higher in the small and midcap space.

In a note, SBI MF said the market has likely discounted a favourable political outcome to a large extent and that sentiment indicators are reflecting complacency in the equity market.

“We believe the markets have already discounted a favourable political outcome to a large extent. This is reflected in both valuations as well as elevated readings on our equity sentiment measure. Equity valuations (as measured through our preferred gauge of earnings yields minus bond yields) turned more unattractive versus bonds over the month given a 13 basis point rise in 10-year bond yields, on the back of rising yields in the US as well as rising commodity prices,” it said in its latest factsheet.

BAFs are one of the key MF offerings in the hybrid space, with 33 schemes managing over Rs 2.3 trillion worth of assets. As they provide exposure to both equity and debt, advisors recommend the offering to first-time investors and to those with a moderate risk profile.