Asset allocation funds - reduce volatility without compromising on the returns

Is it possible to reduce volatility of the scheme NAV without reducing the fund returns? Read my article in Mid-day Gujarati edition today ....

http://epaper.gujaratimidday.com//epaperpdf/gmd/27062016/27062016-md-gm-17.pdf

The English translation is as under:

“Stock markets likely to be volatile next week” – we often see such headlines in the newspapers or similar stories on the television. Volatility, though natural for the stock market, scares majority of investors. In order to reduce the volatility without compromising much on the potential upside, the mutual fund houses have innovated. First they came up with hybrid products. We covered two types of hybrid products – the more popular ones – Balanced Funds and Monthly Income Plans in our earlier articles. Due to the allocation in debt as well as equity, these funds exhibit lower volatility. However, the scheme returns may be lower than equity funds, especially during a secular bull market.

Today, we will discuss about some other strategies adopted by certain fund houses. Such strategies allocate money between equity and debt assets, but change the allocation based on certain parameters.

First of all, let us spend some time on understanding one important principle related to investments. If you combine two or more asset categories, which may be individually risky (volatile) but each one may partly cancel the volatility of the other. Thus, the portfolio would exhibit lower volatility.

This is where the fund houses came up with schemes that invest both in equity as well as debt. Both these asset categories exhibit different price movements at different points of time and in turn partly cancel out each other’s volatility.

Let us say, we start with allocating 50% in each equity and debt. After some time, if the equity market has run up, the percentage allocation to equity would be more than 50%. In such a case, the portfolio must be rebalanced to the original levels, i.e. 50% in each asset class. On the other hand, if the equity market is down, the allocation would be higher than 50% in debt. This time, one would have to sell debt and buy equity.

In either case, one is buying the asset priced lower by selling the one that has appreciated and hence is priced high. This is the classic “buy low, sell high” strategy in action. Now, a fund with static allocation between equity and debt would be achieving this through rebalancing on a regular basis.

The balanced funds and MIPs have delivered reasonably good performance over the years. Rebalancing, as explained above, has played a good role in that performance. Through reduction in volatility, the funds have been able to deliver performance that was average of the two categories.

Now comes the next question. Is it possible to do better than that? That is where funds have launched schemes that do not stick to a desired percentage allocation, but change the allocation based on some formula. This formula depends on the valuation of one or both the asset classes.

Some of the schemes in the market use equity valuation parameters like Price-to-Earnings ratio, or Price-to-Book Value ratio, or a combination of both. One of the schemes uses Price-to-Earnings ratio for equity while simultaneously comparing it with the yield on 10-year Government Securities.

These funds have lived up to the promise – lowering the volatility without reducing the returns too much.

It’s a good category to explore for investors. However, a deeper analysis is warranted since the alternatives can have significant differences among them.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.