Know How To Tide The Market Cycle With Mutual Funds

When it comes to investments, controlling your emotions is one of the most crucial factors. This can be achieved to a great extent by setting realistic returns expectations. Further, we believe that adopting tactical asset allocation is much more beneficial than strategic asset allocation. Read the report to understand why this is so


 American polymath and one of the founding fathers of the United States of America, Benjamin Franklin once very rightly said, “Change is the only constant in life. Your ability to adapt to those changes will determine your success in life.” This applies to investments as well. Returns from investments are never constant unless you have invested in fixed deposits. Variance in returns differs from one asset to another, as can be seen from the infographics presented below.

The above image clearly shows how returns from different assets have different volatility levels. Understanding this would help you to make better investment choices. Markets run in cycles and being overweight on different assets or asset classes is important to have a better investment experience at different points of time. This article would give you more insights with respect to the market cycles and how to tide them with the help of different categories of mutual funds.

The image presented above is an illustration of how a market cycle looks like. It starts with optimism and runs up till the point of euphoria, which is the stage where there is maximum financial risk. Further, when the markets start to move down, anxiety seeps in and a stage is reached when investors deny the market fall. On further fall, the fear factor comes home to roost and investors hit the panic button. That is when the markets move further down towards depression and this is the point where there is maximum opportunity for financial gain. Slowly then, hope for recovery emerges which again leads towards optimism and that is how the cycle continues.

Looking at the illustration, it may seem that it is easy to time the market. However, that is not the case. Many investors have tried it and failed. The market continues to surprise even the most hardened investor. And even though there are techniques such as price to earnings (PE) that is used by many to time the market, using it is burdened with its own flaws. The concept driving this is simple: the markets are not triggered as much by prices as they are by emotions. Hence, betting on market sentiment is much more important than the price. This is not to say that we deny the importance of PE; it is just that we do not support its use in isolation.

Expectations and Reality

It often is the case when investors carry very unrealistic returns expectations from their investments. It is not their fault, but at times financial advisors or other market intermediaries fail to explain and set realistic expectations for all such investments.



In the above image, you can see how investors expect their money to grow. The average one-year rolling return of Nifty 50 Total Returns Index (TRI) over a period of 10 years is 9.87 per cent. This is what investors think they would get every year and so it is assumed that Rs100 invested this year will becomeRs109.87 next year and Rs20.70 the year after that and finallyRs256 after 10 years. Their return expectation is linear but what is the reality? See the image below to get a better understanding.



As can be seen, there is a huge gap between what the investors expect and the reality. This is where the behaviour game begins with most investors giving in to fear and making a hasty exit from their investments at the wrong time. Hence, it is prudent to set realistic returns’ expectations well before investing. This can be done by understanding the purpose of investment and your risk appetite. Let us assume that your investment horizon is for three years and you are a moderate to aggressive risktaker. You invest in equity and so what should be your return expectation?



The graph illustrates the return distribution of equity for three years (Here we studied 1,724 three-year observation over a period of 10 years). We see that in some years returns are greater than 20 per cent while there are also years when equity has generated negative returns. Nonetheless, most of the time returns range from 9-12 per cent. Hence, the returns’ expectations should be anywhere between 9 per cent and 12 per cent every year. Therefore, 10 per cent is something that you can expect on a conservative basis. If returns’ expectations are unrealistic, your behaviour bias won’t let you tide the market cycle.

Riding the Market Cycle

For successfully riding the market cycle you need to understand which asset allocation is best suited at a particular state of this cycle. There are two major asset allocation strategies that are adopted globally. One is strategic asset allocation and the other is tactical asset allocation. Let’s have a brief understanding of both of them.

Strategic Asset Allocation : Strategic asset allocation is technically sticking to the pre-determined asset allocation between various asset classes and restoring or rebalancing it periodically, typically every year. This is a plug-and-play asset allocation style and usually suitable for those who do not wish to actively manage their investments.

Tactical Asset Allocation : Tactical asset allocation is the exact opposite of strategic asset allocation as the asset allocation changes dynamically. Hence, this strategy is also termed as dynamic asset allocation. Here, the asset allocation changes with changes in market dynamics and economic situations. Here at DSIJ’s MF Research Desk we believe in having tactical asset allocation in place that helps us to make timely switches between various asset classes depending upon the market situation. For this purpose, we have designed our proprietary tool Equity Sentiment Index that helps us provide timely signals with respect to entry and exit from the equity market.



As you may have witnessed, the Equity Sentiment Index has provided timely alerts regarding when to enter and exit from the equity market. This became more evident during the global financial crisis of 2008. At that time, our index pointed to exit in October 2007 itself. Even if we were to wait for it to confirm, we may have exited equity mutual funds – though not completely – in December 2007 and would have invested in debt mutual funds, specifically those that follow the duration strategy.

Furthermore, we would have started entering equity mutual funds, starting off with large-caps in a staggered manner in September 2008 itself and by December 2008 our portfolio would have been more tilted towards equity mutual funds and we would have exited from the debt funds that follow a duration strategy to those which follow the accrual strategy and hold short-term papers.

Note: It is to be remembered that adopting such a strategy might incur costs such as exit load and short-term capital gains tax. However, our study has shown that incurring such a cost is more beneficial than incurring big capital losses.

Thus, you can see how our proprietary tool is helping us take timely tactical decisions. We use this tool to decide asset allocation for our ‘MF Power’ product that helps investors create wealth over long-term. This unique tool technically captures the corporate earnings and debt market dynamics.

For investors who do not have access to such sophisticated tools, a combination of PE and market capitalisation to GDP (giving them equal weight) can be used to determine when to move away from equity. Here you may consider their moving averages. For this you can look at 50-Day and 200-Day moving averages. If the 50-Day moving average crosses the 200-Day moving average from below, then you can shift your asset allocation more towards equity mutual funds and if it crosses below 200-Day moving average, then you may shift from equity mutual funds to debt mutual funds.

Conclusion

In order to successfully tide the market cycle with mutual funds, it is important to understand that you need to control your emotions. This can be achieved to a great extent by setting realistic returns expectations. Secondly, we believe that adopting tactical asset allocation is much more beneficial than strategic asset allocation. The purpose of strategic asset allocation is not to tide the market cycle but the purpose of tactical asset allocation is to do so.

And though tactical asset allocation would require you to incur cost in the form of taxation and exit load, it is better to do so rather than staring at big capital losses. However, one needs to remember that market timing should be done only if your ultimate goal is wealth creation. If you wish to achieve any of your financial goals, then strategic asset allocation is the best strategy to adopt.
 

“Time and again, in every market cycle I have witnessed, the extremes of emotion always appear, even among experienced investors. When the world wants to buy only bonds, you can almost close your eyes and buy stocks. ”

Michael Steinhardt (American Hedge Fund Manager)