Do not invest in dynamic bond funds!

Dynamic bonds are debt mutual funds with a flexible investment strategy. There is a perception that they funds can be used to take advantage of interest rate movements to maximise gains.  Unfortunately, these funds do not reward investors enough for the effort and risk involved in its investment strategy. Which is why I believe that one should not invest in dynamic bond funds.

Investment strategy: Typically, when the interest rates are expected to fall, the fund manager will increase exposure to long-term bonds. When the interest rates are expected to increase, the fund manager will move to short-term bonds.

Such a strategy combines the two ways in which debt funds produce returns: capital gains (due to rate movements) and interest income from bonds.

A couple of days ago, I had mentioned that debt funds which invest in short-term bonds out-perform other categories including dynamic bond funds. Read that post here.

In this post, I would like to highlight the performance of dynamic bond funds with the same data set.

Plotted below is the CAGR calculated from annual returns from Value Research versus the standard deviation of the annual returns for different durations.

CAGR is the average rate at which an investment has compounded annually - a measure of reward.

Standard deviation is the extent of deviation of each annual return from the arithmetic average - a measure of risk.

The data points represent all debt mutual funds. Dynamic bond funds are shown in red.

12-year CAGR vs. 12-year standard deviation

dynamic-bond-funds-1Only two 12 -year old dynamic bond funds. They have done better than long-term funds: typically same reward at much lower risk. However, the short-term fund have done better.

If dynamic funds had indeed played the interest rate cycle well, they should have beat the short-term fund as well.

10-year CAGR vs. 10-year standard deviation

dynamic-bond-funds-2

Again the same conclusions as above.

5-year CAGR vs. 5-year standard deviation

dynamic-bond-funds-3

Short-term funds have done well in the last five years when rates were high. So should have dynamic bond funds if they had had enough exposure to short-term funds.  No evidence of that.

Conclusion: Stay away from dynamic bond funds. They are better than long-term funds. That is all that can be said. However, that is like saying a rock is better than a hard place!

Long-term funds are not of much use. They lose during rate hikes what they gain during rate cuts.  Dynamic funds fare better because of their 'dynamism' but have not managed to outperform short-term funds.

As mentioned at least thrice earlier(!), investors who stick to short-term funds are more than likely to do much better.

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15 thoughts on “Do not invest in dynamic bond funds!

  1. A.Sundaram

    Ha,Ha!Pattu,the wise man,has arrived at the correct conclusion based on his mathematical and analytical skills while I learnt it the hard way-by actually investing 🙂

    Reply
      1. A.Sundaram

        Frankly,only at times.Trial-and-error methods to succeed need 2 vital ingredients-luck and prayers! 🙂

        Reply
      1. A.Sundaram

        Dear Muthu,
        Million-dollar question-still hoping that FB will magically retrieve my original identity so that I can access several interesting exchanges with my friends that took place thro' PMs.

        Reply
  2. A.Sundaram

    Ha,Ha!Pattu,the wise man,has arrived at the correct conclusion based on his mathematical and analytical skills while I learnt it the hard way-by actually investing 🙂

    Reply
      1. A.Sundaram

        Frankly,only at times.Trial-and-error methods to succeed need 2 vital ingredients-luck and prayers! 🙂

        Reply
      1. A.Sundaram

        Dear Muthu,
        Million-dollar question-still hoping that FB will magically retrieve my original identity so that I can access several interesting exchanges with my friends that took place thro' PMs.

        Reply
  3. Ramamurthy

    Instead of making an emphatic statement like "DONT INVEST IN DYNAMIC FUNDS" I would suggest you tone it down.It all depends on individual,s targets, investment horizons,risk apetites etc.What is good for you need not be good to me!!

    Reply
  4. Ramamurthy

    Instead of making an emphatic statement like "DONT INVEST IN DYNAMIC FUNDS" I would suggest you tone it down.It all depends on individual,s targets, investment horizons,risk apetites etc.What is good for you need not be good to me!!

    Reply
  5. kalyan

    It is very difficult to pick a good debt fund. Two years back when trying to identify debt funds I noticed that the top 10 funds for any long duration is always a healthy mix of all type of funds. That is when I decided that my debt portfolio is 50% HDFC short term opportunities and 50% Reliance money manager thinking that entering and exiting will be easier due to low variance. It is nice to see more comprehensive mathematical analysis here.
    I still have some long term and dynamic funds due to the increase of long term tenure to 3 years.

    Reply
  6. kalyan

    It is very difficult to pick a good debt fund. Two years back when trying to identify debt funds I noticed that the top 10 funds for any long duration is always a healthy mix of all type of funds. That is when I decided that my debt portfolio is 50% HDFC short term opportunities and 50% Reliance money manager thinking that entering and exiting will be easier due to low variance. It is nice to see more comprehensive mathematical analysis here.
    I still have some long term and dynamic funds due to the increase of long term tenure to 3 years.

    Reply
  7. Rick

    Are short term funds good for long term investment?I take the risk in equity funds. In debt , I will rather play safe. In which genre should I invest for long term if my risk appetite is low.

    Reply

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