Do You Really Need Debt Funds In Your Portfolio?

Although an all-equity portfolio may look tantalising for its possibility of creating wealth, investors must also take into consideration the risk and return probability. As such, adding debt to your portfolio could give it the right balance and security, as a study conducted by DSIJ proves

After registering a low in March 2020, the equity market has not looked back. Not just that, the performance of the market has been quite stunning. Nifty 50 Total Returns Index (TRI) registered a low of 10,710 on March 23, 2020 and as on April 23, 2021 it was 20,392. In this period, Nifty 50 TRI generated 64 per cent of annualised returns. This can very well be seen in the graph presented alongside.

 According to the Securities and Exchange Board of India (SEBI) data, new dematerialisation accounts between April 2020 and January 2021 surged to an all-time high of 1.07 crore. Experts believe that smooth and easy access to stock markets due to technology has led to such a rise. Definitely, this can also be very well-attributed to the rally that the equity market provided in this period. In fact, this rally has also led mutual fund investors to exit from mutual funds to invest directly into stock markets. This has left many wondering as to whether at all one needs debt mutual funds. In this article we would be carrying out a study wherein we would try to answer this question.

The major problem with investors is their perception about the equity market. Most investors often treat the equity market as an easy money minting machine. In fact, these days we can also see a lot of share market trading classes as well. But the true fact is that most of these classes vanish during the bear run. Therefore, it is always better to have the correct perception about any instrument you are investing in. The equity market tends to reward those investors who understand the inherent risks associated with it and still remain invested.

While designing an investment portfolio, an investor might have either one or a combination of the below mentioned three core objectives:
1. Protect capital
2. Provide regular income
3. Create wealth.

However, while constructing an investment portfolio, some may opt for an all-equity portfolio in order to achieve their financial goals. Some might even have higher exposure to focused funds, sectoral funds or even thematic funds. However, we believe that asset allocation between equity and debt is the ideal way one should approach portfolio construction. This is because it can help you strike a perfect balance between safety and growth.

Equity and fixed income or debt are different types of asset classes with different risk and return profiles. On the one end, equities have the capability to deliver better inflation-adjusted returns compared to debt over the long term. Equities are one of the most accepted asset class for wealth creation over the long term. Depending upon the investors’ risk profile and financial goals, equities should form a part of an investor’s portfolio. Fixed income, on the other end, offers stability of returns and capital protection to some extent. Compared to debt instruments such as bank fixed deposits, small savings schemes, bonds and debt mutual funds, equity inherits higher volatility.

In case of equity, returns are unpredictable and the possibility of capital loss is higher when compared to debt. Over longer time horizons, equity usually outperforms most asset classes and the probability of capital loss reduces too. Equity plays a vital role in wealth creation whereas debt ensures stability in the portfolio. Speaking about the returns that debt funds typically offer, it depends on various factors such as inflation expectation over the investment horizon, real rate of return, credit risk premium, and maturity and illiquidity risk premium. The asset allocation mix between equity and debt depends on two major factors: your risk appetite and investment horizon. Higher allocation to equities is of benefit for longer investment horizons. On the contrary, in shorter investment horizons investing in debt is more beneficial.

The Study
In order to understand whether at all you need debt funds in a portfolio, we carried out a study wherein we created different portfolios of equity and debt. In total we studied around six portfolios with different weightages given to equity and debt. Further, we have assumed that you invest Rs one lakh in each of these six portfolios. The study period is from April 2006 to March 2021. Moreover, we have considered Nifty 500 TRI and CCIL All Sovereign Bonds TRI as the representative of equity and debt, respectively.

For a better perspective we have listed down the six portfolios that we would be studying:
✓ 100 per cent equity
✓ 80 per cent equity and 20 per cent debt
✓ 60 per cent equity and 40 per cent debt
✓50 per cent equity and 50 per cent debt
✓ 20 per cent equity and 80 per cent debt
✓100 per cent debt.

"You should have strategic asset allocation mix that assumes that you don't know what the future is going to hold."

Ray Dalio

Post looking at the above graph, you might clearly conclude that investing in an all-equity portfolio is the best way. However, if we look at the year 2008 when the world was facing a global financial crisis and the markets tanked close to 30 to 40 per cent, it was all-equity funds that lost the most whereas an all-debt portfolio provided stable returns. Also, if you notice, an all-debt portfolio never went into the negative territory. In fact, the all-debt portfolio and 20 per cent equity and 80 per cent debt portfolio seem to be quite stable and won’t shock you with any negative surprises. However, when it comes to growth, they didn’t perform that well compared to other portfolios. In order to get better insights let us look at its risk as well as return measure.

If we look at the risk of all the portfolios as measured by standard deviation and downside deviation, we can clearly say that adding debt to the portfolio definitely reduces risk. Not just that, it even increases the risk-adjusted returns metrics as measured by Sharpe and Sortino ratios.

Conclusion
Although an all-equity portfolio seems to be quite rewarding, the risk that it carries is inevitable. Therefore, for most investors, adding debt funds to the portfolio make more sense.

Doing so would reduce your portfolio risk to quite some extent. And this was evident even in the study since the addition of more debt reduced the risk proportion of the portfolio. Having said that, to decide your asset allocation you need to first assess your risk profile. Assessing your risk profile will help you know how much risk you are able and willing to take.

Say, if you are a conservative risk-taker, investing 30 per cent in equity and 70 per cent in debt would be more ideal. However, if you are an aggressive investor, you can consider investing 80 per cent in equity and 20 per cent in debt. Another way to decide your asset allocation is through your time horizon and financial goals. Let us say that you are an aggressive investor but your investment horizon is only of two months. In such a situation, despite being an aggressive investor it is better having an all-debt portfolio.

Moreover, if you are planning for financial goals that are your needs such as child’s education, child’s marriage, your retirement, buying first house or car, then in such cases being a bit conservative even on the equity front is quite important. What this implies is that for such financial goals you can avoid investing in small-cap funds, sectoral funds, thematic funds, etc. You can consider allocating and playing around them for your wealth creation goal. At the end, we would like to conclude that indeed debt funds should play an integral part of any investment portfolio. However, the level of exposure can be different depending upon one’s risk profile and financial goals as discussed above.