Investment planning: How dynamic asset allocation strategy ensures superior returns

New Delhi | Published: November 7, 2018 12:15:59 AM

NSE has launched two dynamic asset allocation indices: NIFTY 50 & Short Duration Debt-Dynamic P/B index and NIFTY 50 & Short Duration Debt-Dynamic P/E index

Investment planning: How dynamic asset allocation strategy ensures superior returns (Illustration: SHYAM Kumar Prasad)

By Mayank Joshipura 

There are two popular approaches to asset allocation. First, strategic asset allocation is where the asset allocation decision is based on the risk profile and financial goals of an individual. Second, dynamic or tactical asset allocation which calibrates exposure to different assets classed from time-to-time based on their relative attractiveness.

The idea behind dynamic asset allocation strategy is “buy-low and sell-high”. The average alpha attributable to performance chasing behaviour is 2% per annum. So finding a disciplined rule-based approach to dynamic asset allocation that generates superior returns is not easy but not impossible either. Can we really do that?

We have an answer to this here. National Stock Exchange of India on October 1, 2018, has launched two dynamic asset allocation indices. NIFTY 50 & Short Duration Debt—Dynamic P/B index and NIFTY 50 & Short Duration Debt—Dynamic P/E index.

Nifty Dynamic Asset Allocation

The Nifty Dynamic Asset Allocation Indices individually capture the performance of hybrid portfolios where asset is allocated among Nifty 50 TR Index (equity component), Nifty Short Duration Debt index (debt component), Nifty 50 TR Index with Short Nifty 50 Futures index (Arbitrage component) and CBLO based on Price-Earnings ratio (P/E) or Price-Book ratio (P/B) of Nifty 50. Both indices work on the principle of “buying low and selling high”. Increase equity exposure when valuations are relatively cheap and reduce equity exposure when valuations are relatively expensive.

How does it work?

It follows following asset allocation rules make the entire exercise objective and bias-free.

Equity allocation (NIFTY 50 TR) is determined by an asset allocation model which compares the current value of P/E or P/B of Nifty 50 with the average, maximum and minimum P/E or P/B of Nifty 50 in previous seven years.

Maximum allocation to equity component is 80% and minimum allocation is 65% including arbitrage.

In case the model prescribes an allocation to equity that is lower than 65%, the equity arbitrage is used to maintain the equity allocation at 65%. Arbitrage is done by giving equal allocation to Long Nifty 50 TR index and Short Nifty 50 Futures index.

Remaining allocation is given to debt component (Nifty Short duration debt index), hence maximum allocation to debt (including CBLO) component is 35% and minimum allocation is 20%.

In case arbitrage is used, 10% of the asset allocated to Nifty 50 Futures index (short) is allocated to Nifty 1D Rate index (CBLO component) in order to capture the margin requirement.

The month-over-month change in allocation to equity component (Nifty 50 TR, excluding arbitrage component) by asset allocation model at the time of rebalancing is capped at 10%.

The graphic shows the performance of both versions of dynamic asset allocation indices since April 1, 2005. Both indices offer decent CAGR with near half the volatility of equity. They have done well during bear markets as well as the recovering markets. Those who are happy with 10-15% returns on their long-term investments with lower than equity markets volatility should certainly look at this approach of investing.

Implementation challenges

One may end up investing in four different products at the same time if the model suggests an equity allocation of less than 65%, and that includes shorting of index futures. Monthly rebalancing of the index leads to high implementation costs and will have adverse tax implications such as short-term capital gains tax on debt and equity.

It is bundled and offered as low-cost tax-efficient ETF product, it would be difficult to implement it at an individual level. I am not too sure whether any fund house will soon come up with a low-cost, low-tracking error version of ETF tracking NSE Dynamic Asset Allocation indices. However, this is the step in the right direction and we hope to see an increased focus on asset allocation, a key decision in an investor’s journey towards achieving financial freedom.

The writer is professor & chairperson (Finance), School of Business Management, NMIMS, Mumbai

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