Managing Portfolio In Times Of A Bubble
Even when the markets turn volatile due to various external factors, it is a proven fact that merely watching from the sidelines is of no help. During such times it becomes a necessity to adopt a strategy that will help you to mitigate downside risk. And one of the best strategies is to engage in wise portfolio management
The four most dangerous words in investing are: This time it’s different.” These were the words of John Templeton, a legendary investor and mutual fund manager, who founded the Templeton Growth Fund. It is also said that more money has been lost due to these four words than at the point of a gun. Consider the ongoing scenario: the equity market has probably generated one of the best returns in the shortest span of time over the past few months. In fact, in the last five months, equity indices are up by more than 50 per cent. Record low interest rate, dovish central banks, gush of liquidity and a vaccine on the horizon are some of the factors that investors believe to be different this time. This surge in the equity market is not something specific to the Indian equity market alone. Equity markets across the globe are rising in a synchronised way. If we take into consideration some of the major indices, our recent climb will actually pale in comparison. If we exclude the FTSE 100 of UK, all the other major markets have outperformed us. In fact, our equity market represented by Nifty 50 was one of the worst hit during the March 2020 fall and not the best to post a recovery.
Nonetheless, there are investors who are angst-ridden, worried by the fear that the party in the equity market could come to a screeching halt and that the fizz may dissipate soon. Extreme valuations, border tension against China and a month that is seasonally considered the weakest for equities provide ample reasons for an investor’s anxiety.
Strategy for Mutual Fund Investors
Against this background it becomes a necessity to adopt a strategy that will help you to mitigate downside risk. At the same time we all know now that remaining on the sidelines is not an option. Especially in an environment like this one in which the central banks have declared a lasting low-interest rate environment and injected historic amounts of liquidity into the financial system. Besides, there is also change in stance by the US Federal Reserve, which means one may not see the repetition of the tapper tantrum of 2013. In addition, governments around the world are also not leaving any stone unturned to revive the economy. Therefore, opposed to fearing bubbles and trying to forecast them, it makes more sense to have a solid plan to survive and ideally thrive during a bubble.
Reading the data of mutual fund inflows, it shows that investors are already charting out some active strategies. On the face of it, it appears that mutual fund investors are showing signs of nervousness and are in the process of booking profit or moderating their inflows through systematic investment plan (SIP). Data from the Association of Mutual Funds in India (AMFI) reveals that net inflows to the equity mutual fund have been showing a continuous decline since March 2020. From the recent high of Rs 11,723 crore of net inflows reached in the month March 2020, the inflow has tapered down significantly and was negative for the month of July 2020.
It was the first time after March 2016 that the net inflows into equity dedicated funds turned negative. Nonetheless, gross inflows have remained intact and increased by 3 per cent sequentially in the July 2020. What led to negative net inflows in July was 23 per cent increase in redemption. As markets saw a rally of more than 50 per cent from their recent lows, many investors preferred to book profit, which led to rise in redemption. Nevertheless, talking to experts and market participants, it seems that many high net worth individuals (HNI) have redeemed from equity MF schemes and are now directly going to the equity market instead of taking the MF route. The impact of this is also visible in the monthly SIP numbers.
As far as monthly instalments of investment in the form of SIP are concerned, these too are showing a continuous dip. From the high of Rs 8,641 crore reached at the end of March 2020, it has come down to Rs 7,831 crore at the end of July 2020. This is a 22-month low figure. Last time we saw such a low figure was in September 2018. This drop has come despite increase in number of investors adopting SIP. More than 20 lakh investors have started SIP in the last few months. The reason for this conundrum is that a larger number of retail investors with lower SIP value have entered the game while HNIs with higher SIPs have exited.
It implies that there are many investors, and especially retail investors, who are still placing their faith in SIPs and parking their savings in mutual funds. Does this mean that other investors should also follow the same strategy? Or should you redeem part of your corpus and wait for a correction to happen? As for SIP investors, should they continue with SIPs since any minor correction is not going to cause much impact on their total AUM or returns? The answers to these questions lie in better asset allocation.
Asset Allocation: The Holy Grail of Smooth Investment Experience
We have been a strong proponent of asset allocation from a better investment experience perspective. This may not give you the maximum returns; however, it will save you from sleepless nights. This does not mean that they fail to generate better returns. On the contrary, research shows that they tend to give better risk-adjusted returns in the longer duration. Asset allocation is a process wherein you segregate your investments in different asset classes such as equity, commodity and fixed income based on your risk profile. The idea behind asset allocation is that different assets will give you different returns in different market conditions and hence remaining invested in every asset class will help you get smoother returns instead of taking you through a lot of twists and turns.
The above graph shows movement of Rs 1 lakh invested in different assets and that if the same amount would have invested in a portfolio. Here portfolio means portfolio with asset allocation with equal weightage and re-balancing.
As one size does not fit all, there are different asset allocation strategies. Broadly, there are two different types of asset allocation strategies. First is the strategic asset allocation (SAA) and second is the dynamic asset allocation (DAA). Studies show that asset allocation explains a majority of your long-term portfolio performance. Under SAA you determine a basic policy mix and then stick to the same. This refers to assigning a proportion to each asset class based on its expected returns. For example, if equities have historically given 12 per cent returns, bonds have given 8 per cent and gold has given 10 per cent returns per annum, then a mix of 50 per cent equities, 40 per cent bonds and 10 per cent gold would generate an expected target return of 10.2 per cent per annum. You need to keep rebalancing at equal intervals.
DAA is an active asset allocation strategy in which you can continuously change and adjust the asset mix depending on the market and economic conditions. It moves opposite to constant-weighting asset allocation that is adopted under SAA. For example, in the dynamic strategy, you would add equity to your portfolio when it is cheap and sell when it is high. A similar strategy can be adopted for the debt market. It is an active management strategy at the macro level that tries to capture short-term opportunities in the markets. You can choose any one of the choices or a mix. However, what is important is that it needs to be implemented consistently. We at DSIJ follow an equity sentiment index that comes under DAA. It is a more active form of asset allocation and requires constant monitoring.
In the graph above, the equity sentiment index as represented with a blue line is calculated based on the valuation of frontline equity indices and a 10-year benchmark G-Sec yield. This gives us a sense how two major asset classes are stacked against each other in terms of risk and return. Accordingly, we take a call on asset allocation. Gold invariably remains 5 per cent of the portfolio as it has a negative correlation with other asset classes. For investors who want to adopt a dynamic asset allocation, they can even use price to earnings ratio of Nifty or Sensex to understand the attractiveness of equities and accordingly can adjust their equity and debt portfolio. Asset allocation may appear easy but it is very difficult to practice. Hence, in the following paragraphs we will explain how you can use it.
Asset Allocation and Rebalancing
Many a time, SIP is touted as panacea for retail investors as it helps them for rupee cost averaging. When the market is low, you can purchase more units and when the market is high your buy fewer units. This is perfect for the new investments that you are making but what about the corpus that you have already built over a period of time? The larger your SIP amount or larger the corpus you have accumulated over a period, every new unit you purchase will make an insignificant impact on your overall corpus or returns.
Consider, for example, that you have been committed to a monthly SIP of Rs 5,000 and in the last eight years have accumulated Rs 5 lakhs of corpus. Now every incremental SIP is just 1 per cent of your total corpus. Hence, even if the market falls by 10 per cent and you accumulate more units, the total impact on your corpus will be even lower. Nonetheless, what will hurt you more is the 10 per cent fall in your accumulated corpus. And, therefore instead of concentrating on SIPs in a falling market, it is more important to pay attention to your accumulated corpus. In extreme conditions of market disruptions, as for instance the one we are going through now, just continuing SIPs will not do. You need to put into practice more active measures to lead your portfolio towards a better outcome.
Revisit your asset allocation plan and check your needs and the motive for having started your SIP. Was it for growth, income or liquidity? You can then rebalance it to protect downside risk while making the most of market corrections. Track your allocation closely and if you have more equity than you are comfortable with, invest in fixed income and commodity funds to rebalance and give some cushion during a phase of market correction. But looking at the valuation of the market, we suggest avoiding being aggressive while investing in equities as of now. And if the reason to invest is the fear of missing out or wanting to earn as much as your neighbour is managing to do even with an IQ lower than yours is no valid reason at all.
It is most likely that in recent times, on account of the sharp surge in the equity market, the equity component of your portfolio would have overshot its limits in most portfolios. Rebalance the portfolio to its pre-determined allocation. This will not only help book profits but also reduce the risk since the portfolio’s exposure to equity has been brought down to a level that you are comfortable with. If the markets correct sharply, the impact on the portfolio will be lower and rebalancing at that stage will mean buying more equity when the markets are down. Although rebalancing is done annually keeping in the mind the taxation and exit load, in a situation like this, quarterly rebalancing will be more helpful. The same strategy of rebalancing the portfolio should be followed by lump sum investors.
Switching to Funds with Mix of Debt and Equity
For investors who cannot stomach extreme volatility or are close to achieving their financial goals and are therefore not willing to take any further risks, a reasonable option would be to move to funds that invest in a mix of debt and equity. As per SEBI classification, there are seven types of hybrid mutual funds. These are segregated based on their exposure to equity and debt. Depending upon your risk-taking ability you could choose any one of them or a combination. Remember that different categories have different tax treatment depending upon the exposure of equity and debt in the fund. Two important categories that you can consider are the balanced advantage fund and dynamic asset allocation fund.
Balanced advantage funds are dynamically managed equity mutual funds that typically alter their equity allocation between 30-80 per cent depending on market valuations and after considering the price-earnings ratio. When valuations are high, they reduce their equity allocation and when low, increase it. Dynamic asset allocation invests in a way that minimises risk based on market trends and is targeted for low-risk appetite investors. This category of funds doesn’t involve having a target investment mix of assets. Therefore, the fund manager has a high degree of flexibility while rebalancing. The success of funds depends not just on market conditions but also on the manager’s decision-making ability. Therefore, check the track record of the fund and the fund manager before investing.
"You should have a strategic asset allocation mix that assumes that you don't know what the future is going to hold"
Ray Dalio
An American billionaire hedge fund manager
Cash is King
There is no harm in keeping up to 10 per cent of this least exciting asset in your portfolio. It’s among the safest asset and easiest to use. The best part about cash is that when all other assets collapse in price, cash will remain the same tomorrow. It will help you to take benefit of any sharp correction in the market. The above discussion does not mean that we are predicting the market to sell off sharply. It’s only that we are not finding the required valid reasons to give us the confidence that the market will sustain its rise. It is more likely to struggle to move higher from here. So is there any point in chasing the trend? Nevertheless, developments in the last week show that a sell-off is more likely now. Remember that market corrections of 10 per cent are normal and can happen at any time.
Adopting some of the strategies explained earlier will only help you protect your wealth.