A good investment option amidst volatility

We looked at various asset allocation schemes last time. This time, we will discuss a variation of these schemes - dynamic asset allocation schemes.

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The English translation is as under:

Last time, we covered asset allocation funds. This time we will look at a variant of the same, known as “dynamic asset allocation” funds. While we discussed about investing in multiple asset categories, the focus of the discussion was about maintaining certain proportion in each of the two or three asset categories.

However, periodically, when one asset category becomes costly, does it make sense to reduce the allocation? Similarly, should one increase the allocation in the asset that has become cheaper? There is a school of thought that suggests, “Yes, we should”.

Mutual fund companies have come up with schemes that work on such principles. These schemes invest in more than one asset categories – in most cases these invest in two assets. Most such schemes allocate money between equity and debt.

The allocation between equity and debt is altered periodically. In order to determine the allocation to the two asset categories, there are two approaches:

1.     The fund manager alters the allocation based on his/her views on the two asset categories.

2.     The allocation would change on the basis of some pre-decided formula.

In the first case, when the fund manager is bearish on equity market, the scheme would reduce equity exposure. However, when one is bullish about equity, the allocation would go up.

In the latter, most often, valuation determines how much should be allocated where. The allocation would be reduced from (or increased in) the asset that has become costly (cheaper) as indicated by certain valuation parameters. However, some of the schemes only look at valuation of equity. There is at least one scheme that compares the valuation of equity and debt and changes the allocation accordingly.

The valuation parameters:

For the purpose of evaluating equity valuation, most consider the P/E ratio or the P/BV ratio. Both these ratios are popular indicators of valuation. As a thumb rule, it is believed that higher the number, costlier the market (or a sector or a stock). Fund schemes follow a certain pre-defined pattern through which the allocation in equity is reduced step-by-step when the valuation goes up and increased when the valuation goes down.

In one case, the scheme’s allocation is altered based on the gap between the yield on Government Security with 10-year maturity and the “earnings yield” for equity. The earnings yield is the inverse of P/E ratio.

These are schemes designed to reduce short-term fluctuations in the scheme’s NAV. At the same time, such schemes are expected to deliver at least as much as a fund that evenly allocated money between equity and debt.

Very often, investors have compared such schemes to pure equity funds. That is a mistake. Given that these schemes invest at least some proportion and often a large chunk in debt securities, it would be improper to compare these with pure equity funds.

Should an investor consider investing in such schemes? Well, that entirely depends on whether the investor needs such a scheme in the first place. Having said that, one may consider such a scheme with an expectation of reduced price fluctuations compared to a hybrid scheme that does not change the allocation.

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.