Jagdish Seth, a successful businessman, is lured by the returns generated in the stock market, especially in the bullish phase that is being witnessed for the past five years. However attracted he is, at the back of his mind he is reluctant to take exposure to equity. The probability of capital erosion grips him with fear. Especially after the market corrected in August and the increasing volatile moves. Seth remembers the downturn in 2000 when he daringly invested in the market and the IT bubble burst cost him dear.
And now, with the market peaking every other month, exposing the wealth portfolio to the vagaries is considered near fatal. A study carried out by The Financial Express reveals that the Sensex volatility in the month of August was much higher than the ten-year average. Importantly, the volatility (as measured by standard deviation of daily returns) has been steadily increasing in the past two years. As compared to global markets as well, the risk level in the Indian market has increased, with valuations looking stretched, it may be wise to stay away. Once bitten twice shy, Seth says.
There are many successful and wealthy individuals like Seth around, who would rather churn their money back into their business and invest in traditional assets like gold or real estate. A small sum would be directed towards debt products like PPF, NSC, postal savings floated by central and state government.
?In India, the total investment by an individual investor in equity markets as a percentage of total savings is minimal. This can be attributed to two factors – lack of awareness and risk aversion,? says Balakrishnan Kunnambath, MD & global head of Indian subcontinent, SG Private Banking (Asia Pacific).
Then there are certain savvy investors who tide over the volatile times and still manage to protect their capital. For investors wanting best of both the worlds, i.e. capital gain and protection as well, wealth managers have devised the concept of dynamic portfolio insurance.
Cushioning impact
Portfolio insurance is quite like buying an insurance policy. If an unforeseen event takes place, a certain assured amount is made available to the insurance policy holder and the damage is made good. Similarly, portfolio insurance entails the creation of a portfolio that is dynamically managed to protect the portfolio holder from having the capital washed out, in case of an unexpected eventuality.
Portfolio insurance, also termed as portfolio hedging, is an emerging concept in India, regularly applied in overseas market like the US.
Overseas market like the US and Japan are already developed and matured, and the returns expectation are very less and also not guaranteed. ?As an emerging market, India will have to live with relatively higher market volatility for some time compared to the developed markets. In this scenario, portfolio insurance can actually raise long-term returns and at the same time control downside risks,? says Arpit Agarwal, MD& Group CEO, Financial Services, Dawnay Day AV India Advisors Pvt Ltd.
Essentially, the portfolio manager, based on the client?s risk appetite and the need to guard capital, devise techniques that will enable him to offer portfolio insurance.
Portfolio strategy pyramid
The popular portfolio strategy is to ?buy and hold?, where you build an initial mix (e.g. 60:40 stocks/debt) based on your risk taking ability and then hold the assets till the required time horizon. This strategy holds good when you are buying an index in case of equities, as over a long term (more than 10 years) equity markets tend to outperform other asset classes. But then if you pick up the wrong stocks, and base the portfolio on individual stock picking, you run a huge risk of your capital being eroded. You are partly insured to the extent of the debt portion, assuming it is high quality debt.
The advantage of this is that this is a relatively easy strategy to implement and works exceedingly well at the beginning of the bull-run. Moreover, this strategy tends to be rather passive in nature. Then again there are other hedging strategies that can be used to secure the portfolio and this too has a downside.
Agarwal says, ?Portfolio insurance effectiveness increases with the accuracy of predicting the market volatility. Hedging based on historical volatility numbers may go completely wrong if the present volatility is much higher.? Here Agarwal cites the example of volatility numbers, he says, ?If the long-term volatility figures of the Indian market of approximately 20% were used to insure portfolios, the strategy would go wrong as the average volatility for August 2007 was 37%. The downside is that an over-hedged position by over-estimation of volatility increases the cost of hedging.?
Therefore having a forward looking approach becomes imperative. One of the basic portfolio insurance strategies is to have a constant mix ratio generated. This is again built on the risk tolerance levels of the client. Now, when a mix of debt and equity is built, it is constantly tracked and maintained over a period of time.
Constant mix
Now, suppose you have a 60% equity and 40% debt mix ratio to start with. Over the next quarter, or designated review time, the stock market will have climbed and the value of equity will have risen. By that measure, the proportion of equity would have risen as well. At the time of review, the extra equity portion will be liquidated in way that the 60:40 ratio will be maintained. And in case the markets drop, you will have to chip in more to buy equities and maintain the share. ?This matches up well with the averaging theory where you buy specific amounts when the cost falls to lower your equity holding costs,? says a financial planner. Several testing techniques suggest that over a long period, the capital is protected this way.
But if you are somebody who wants to take more risk then constant proportion portfolio insurance is what experts recommend. Here a multiplier is created to grade your risk taking ability; concepts like floor and cushion are also used here.
Agarwal explains that the ?floor? is the absolute minimum value of the portfolio an investor is willing to accept without getting devastated. For example, for a portfolio of Rs 5 lakh if the investor is willing to accept a maximum of Rs 1 lakh loss over a specified time horizon, the ?floor? is Rs 4 lakh and the ?cushion? is Rs 1 lakh. The Rs 4 lakh may be invested in risk-free coupons and the balance Rs 1 lakh, the investor may buy stocks or other aggressive assets.
The investor may use a ?multiplier? for the cushion to be invested in risky assets depending on the duration and the coupon rate of the underlying fixed income portfolio. For this strategy to successfully work, the portfolio has to be monitored on a dynamic basis and continuously rebalanced, he adds.
There are two more strategies used for portfolio insurance. Option-based insurance is a combination of protection of capital and a passive investment strategy, but this option limits the exposure to market returns. And time-variant approach offers greater exposure to the market but may lead to a floor marginally lower than the opening position due to the increased volatility of aggressive asset classes.
The balancing act
Unlike in CPPI, the multiplier is not fixed in dynamic portfolio insurance (DPI), a technique to balance allocations between risky and non-risky investments in order to maximise returns, which you as an investor need to be aware of. It is based on the market conditions. If the market is performing well then the multiplier will go up and vice versa in case of a bearish market. The risk increases in case of high multiplier so the capital guarantee will go down subsequently.
You must be clear of the minimum yield and also of the partial or capital guaranteed criteria. It is required because on this basis proper mix of risky and non-risky assets will be derived. And here the portfolio manager has to manage the portfolio as per the condition/guarantee specified.
Both CPPI and DPI follow the theory: buy when the market is high and sell when it is down. The risk appetite remains the same over the period irrespective of any market condition. DPI is a flexible technique specifically designed to offer tailor-made solutions and hence it enables an investor to benefit from the tactical view taken in volatile markets with limited or known capital risk.
The common thread
All the four strategies have one thing in common. Each has a condition attached to it, but the condition or constraint makes the every strategy unique. ?Buy? and ?hold? works the best in the bull phase and can give maximum returns. Constant mix works equally well in all the phases but has limited upside and downside.
Buy and hold and constant mix are not exact portfolio insurance as they work on both the side and do not have the capital guarantee attached to it. The other two, CPPI and DPI, have an inbuilt feature of insurance. The main problem in using DPI method is the huge transaction costs involved because of its feature of changing the multiplier according to market conditions. On the other hand, in CPPI, the multiplier is fixed over the period. These strategies are dynamic in nature with an inbuilt feature of insurance.
Static portfolio insurance
In this, you structure your portfolio in such a way that if the equity proportion becomes zero, the initial capital remains intact. For example, if you want to invest Rs 100 with a horizon of five years and the coupon rate for the debt is 8%, the proportion of debt-equity is 70:30. Suppose in the next five years, the equity value comes to zero, on maturity you will receive your capital. This is because the Rs 70 invested in debt for five years, becomes more than Rs 100 post-maturity. It?s a good strategy to protect your portfolio from principal loss. It is generally attractive in a high interest rate environment because more capital can be allocated, unlike dynamic hedging which is attractive in a low interest rate environment.
Hence, a situation-based strategy should be used to benefit from the market. There are a few options available here. Recently JM Financial Services launched a dynamic portfolio insurance facility for their clients. There are several others waiting in the wings to make offers. For mutual fund investors there are a cluster of capital protection plans that are based on portfolio insurance techniques. The offerings in portfolio insurance are only going to rise. People like Seth can now look forward to immerse gently in the choppy waters of the equity markets.