By Hemanth Gorur
A common belief among investors is that diversification along with periodic portfolio rebalancing completely solves the problem of risk in investment. However, investors often go wrong in knowing which asset class to increase or decrease allocation in, and when to do that, if at all.
The asset allocation quilt gives a comprehensive picture of not just the relative performance of different asset classes but also their relative volatility over time.
Creating asset allocation quilt
Anyone can create the asset allocation quilt, which typically consists of ten asset sub-classes like small cap funds, mid cap funds, large cap funds, international funds, credit risk funds, corporate bond funds, G-secs, T-bill funds, gold, and real estate. The first four fall under the equity asset class, next four under debt, and gold under commodities. Annual returns of each asset sub-class across ten years are marked in a 10-by-10 grid, with the years moving from left to right, and the ten asset sub-classes from top to bottom in descending order of their returns. The asset sub-classes can be colour coded for detection of patterns.
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Returns of equity asset sub-classes can be taken from the respective index returns on BSE or NSE. Similarly, debt asset sub-classes can be taken from rating agencies’ index data. Gold and real estate data are available from World Gold Council and RBI websites respectively.
Performance trends in the last decade
An asset allocation quilt created in the above fashion for the last ten years will immediately reveal several things. First, no asset sub-class has managed to retain its top position in consecutive years. Second, the absolute returns of any asset sub-class are not indicative of its ranking relative to other sub-classes. Asset sub-classes with consistently low positive returns can actually rank high in a bad year, while sub-classes with high positive returns may be outperformed by more volatile sub-classes in a bullish year.
Third, each sub-class exhibits a different pattern across the ten years. Small cap and mid cap funds alternate between top two and bottom two positions every year. Gold seems to alternate between being in the top two and bottom two positions every three to four years based on the business or economic cycle.
Sub-classes like large cap and corporate bond funds can retain their position in the top three for two to three consecutive years, and have never figured in the bottom three except for two years. Credit risk seems to slide up and down the rankings every five to six years.
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T-bill funds have never figured in the top five positions, while G-Secs and international funds do not exhibit any discernible pattern. Real estate has never been in the top two positions for any year, and has been sliding down the rankings consistently over the last decade.
Equity asset classes and gold have shown negative returns, while debt asset classes and real estate have never entered negative territory.
How to use the quilt
The quilt gives us two approaches to asset allocation. The first approach is to blindly invest in all ten asset sub-classes with equal weightage, and importantly, not do any portfolio rebalancing every year. For example, if an investor had created a portfolio of Rs 1 lakh by investing Rs 10,000 in each of the sub-classes in 2012 and forgotten about it, her portfolio would have grown to Rs 2.9 lakh in 2022, giving an annualised yield of 11%.
The second approach is to study the relative performance patterns of each sub-class and compile a portfolio that is compatible with their risk tolerance and returns expectations. For example, an investor with low-to-medium risk tolerance who prefers to do portfolio rebalancing every year should avoid small cap, mid cap, and international funds. A combination of large cap funds, corporate bond funds, and gold may work for investors of all risk profiles, provided they limit their portfolio rebalancing to once in a few years.
The writer is founder, Hermoneytalks.com