The Sensex is at all-time high levels while the 10-year bond yield has fallen to below 8.3% levels from over 9% levels in April. In such a situation, the question in everyone’s mind is how much should they allocate to equity and how much to debt. The equity markets appear to have factored in the government’s expectations of a higher GDP growth of 5%, stronger corporate earnings and more project spending. On the other hands, bond funds would benefit if yields continue to decline further as prices and yields move in opposite directions. Factors favouring the debt market include steady decline in domestic inflation besides a fall in international crude prices among others. All eyes are therefore on the December 2 monetary policy announcement from the Reserve Bank of India (RBI) governor.
But the moot question is, can one time the market and more so, make investments based on ‘ifs’ and ‘buts’? The answer is no; it is almost impossible to time the market. Let me cite a few instances. If you remember, in 2007, investors pumped a large amount into equity funds, despite markets being at elevated levels, and valuations being quite rich and ended up losing money during the 2008 financial crisis. Further in 2009, investors hardly invested in equity funds, despite lower market levels and attractive valuations and missed the 2010 rally. Take the instance of gold.
Gold ETFs registered the highest inflows in FY12 when gold prices were quite elevated but there have been net outflows in FY14 when the prices have cooled down. In short, it has been observed that many investors missed the bus when it came to maximising returns.
A simpler and more effective way is to follow asset allocation and rebalance the asset classes periodically. Asset allocation helps investors to divide their portfolio across equity, debt, gold, cash and other asset classes in the optimal proportion based on their risk appetite (tolerance). Thus an investor with an aggressive risk appetite may allocate more to riskier asset classes like equity while an investor with a conservative risk appetite may allocate more to less riskier asset classes like fixed income. Long term asset class studies claim that over 90% of return variations in a portfolio can be explained by asset allocation clearly indicating why asset allocation cannot and should not be ignored.
While most investors in mutual funds follow systematic investment plans (SIPs), this is only half the job done if not followed up with an asset allocation cum rebalancing approach. There are instances when investors may start with an asset allocation approach but may ignore or forget to rebalance. Rebalancing helps to periodically book profits in an outperforming asset class or invest more in an underperforming asset class in order to restore the original asset allocation.
Though many investors may get the product selection right, it is the right asset allocation that helps to cushion the risk in the portfolio and help to maximise risk adjusted returns. For example, if equity is volatile, an allocation to less volatile debt helps to cushion the overall portfolio volatility (risk). Another factor which works in favour of asset allocation is the low returns correlation between key asset classes like equity, debt and gold. This means that the bull or bear cycles in these asset classes generally do not coincide. So if one asset class in a bear phase and subdues portfolio returns, another asset class would do well and cushion the decline. This is the biggest advantage of diversifying across less correlated asset classes.
However, for many investors it may practically not be possible to rebalance manually owing to time constraints, operational efforts and cost involved. Emotional bias towards an outperforming asset class may also lead to investors not rebalancing their portfolio periodically. For such investors, mutual funds offer ready to use asset allocation solutions. Such solutions help investors to enter and exit an asset class systematically rather than by a manual intervention.
The most simple asset allocation solutions are hybrid funds like balanced funds or monthly income plans. They offer a static asset allocation wherein allocations to an asset class are pre-defined and move in a narrow range. The exact allocation within this range is based on the fund manager’s view on the asset class. For example, monthly income plans have a marginal allocation to equities which is generally capped at 20-30%. Another variety is dynamic asset allocation funds (which mostly work on a model like a price-earning or PE ratio) which can typically swing from a pure equity allocation to a pure debt allocation or a mix of both based on what the model indicates. The asset classes here could be two (equity, debt), three (equity, debt, gold) or even four (equity, debt, gold, cash) depending upon the diversification desired.
Some of these solutions may also offer tactical allocation (to benefit from any short term market movements) in addition to the long term strategic allocation across asset classes. Also, the model used may follow a simple PE (price-to-earnings) ratio model or may rebalance using a multi-factor model based on indicators like economic, valuation, sentiment, among others. The underlying parameters used in these indicators could be industrial growth, PE ratio, yields, currency, etc.
Asset allocation solutions are thus the answer to timing the market systematically through a single fund investing across asset classes.
The author is president, Franklin Templeton Investments (India)