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.

Click on the link here to read further.

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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.

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.

Understanding risk-adjusted returns

How do you know whether you are compensated enough for the risk taken? Read my article to find out ...

http://epaper.gujaratimidday.com//epaperpdf/gmd/08022016/08022016-md-gm-12.pdf

The English translation is as under:

Risk-adjusted returns

Last time, we saw standard deviation and beta as measures of risk to compare two or more equity funds. These parameters measure the risk of volatility involved in the equity funds. This volatility could be on account of various factors. However, in most cases, the fund managers take the risk of volatility with an objective to generate high long term returns.

In such a case, it may not be proper to look at returns or risk in isolation. It would be prudent to see if the risk has been duly rewarded or not. Did the fund manager succeed in generating high returns for taking on higher risk?

Investment managers evaluate this question through what is known as “risk-adjusted return”. There are various ways to measure this parameter. The most popular among these is known as “Sharpe ratio”, named after Economist William Sharpe.

Assume there is an investor, who does not want to take any investment risk. Such an investor would have to be satisfied with “risk-free” rate of return. However, in order to earn higher than the “risk-free” rate, one will have to take some risk. Since we are discussing equity funds (a well-diversified equity portfolio) here, the only risk to consider is volatility. Now, by investing in equity fund, the fund manager has taken the risk of price volatility or fluctuations. Is he able to get returns higher than the risk-free rate? If yes, how much? This is what Sharpe ratio captures.

The equation for calculation of Sharpe ratio is as under:

Sharpe ratio = (portfolio return – risk-free rate) / standard deviation of the fund

Higher Sharpe ratio is considered to be better than a lower ratio, as the fund manager rewarded the investors for the risks taken.

As can be seen from the above equation, the excess return generated by the fund is in the numerator, whereas the standard deviation (as we saw last time, standard deviation is a measure of volatility – higher SD means higher risk) is in the denominator.

Higher standard deviation would reduce the Sharpe ratio. So, if the fund manager who takes higher risks gets a lower score. Similarly, higher returns would increase the Sharpe ratio. Thus, someone who can generate higher returns by taking lower risk would have a better Sharpe score compared to others. However, someone generating higher returns by taking high risk might get a similar score as someone who generates lower returns by avoiding risks.

Let us also understand that the numerator is excess return over risk-free rate and not just the return generated by the fund. Even if the fund has generated positive but less than risk-free return, the Sharpe ratio would be negative. This also means that the fund manager could not even generate risk-free returns in spite of taking the risk. Due to this, Sharpe ratio is not always the best indicator since when the overall market is down, most equity funds would also deliver negative or low returns. In such a case, the Sharpe ratio would be negative. Please do not judge this as incompetence of the fund manager. It would be prudent to compare two similar funds on this scale rather than looking at the Sharpe ratio of one fund and arriving at a conclusion.

-        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.

How do you compare the risks in different equity funds

Equity funds are riskier than debt funds - that is well known. However, between two equity funds, how do you know which of the two is riskier? To know more, read the article here, published in Mid-day Gujarati edition today:

http://epaper.gujaratimidday.com//epaperpdf/gmd/25012016/25012016-md-gm-14.pdf


Read the English translation of the same here:

Most discussions about mutual funds are consistent in that equity funds are riskier than debt funds. What do we mean by this? What is this risk?

A lot of investors equate this risk with loss of capital. However, in investment theory, most often, the risk on a portfolio is represented by volatility in the market value of the portfolio. in case of a mutual fund (which is also a portfolio), the volatility in market value is equal to the fluctuation n the fund’s NAV.

So the meaning of the phrase “equity funds are riskier than debt funds” is that “the NAV of an equity fund would be more volatile than that of a debt fund”.

While looking at the portfolio risk, the theorists do not look at the risks that can be removed or reduced through diversification. The volatility in market prices is one risk that cannot be diversified away and hence the discussion is centered around only one risk. As mentioned earlier, it is well known and accepted that equity funds are more volatile than debt funds. Hence, we would only discuss the risk of price volatility of equity funds.

Then the question is: between two different equity funds, how do we know which one is more risky and which is less risky?

There are two important parameters one can look at, viz., standard deviation and portfolio Beta. Both are statistical terms to measure volatility of the scheme’s returns. In both cases, normally the monthly scheme returns are tabulated and then the variation in these monthly returns is measured.

Standard deviation is a measure of variation of various monthly returns round the average of all these monthly returns. Beta, on the other hand, measures the volatility of a scheme’s returns as compared to that of its benchmark.

Standard deviation is a number above zero – a positive number. Higher the standard deviation, higher the risk of volatility. If scheme A’s standard deviation is 25 and that of scheme B is 18, than scheme A is considered to be riskier than scheme B.

Beta would also be a positive number. However, it is always in reference to its own benchmark (in other terms, in relation to the market). A Beta of 1 means the scheme is as risky (or volatile) as the market itself. Beta lower than 1 indicates a scheme that is less risky (volatile) compared to the market and Beta higher than 1  indicates the scheme is riskier (more volatile) than the market.

Both these numbers are available in the fact sheet of most of the funds. If these are not available in the fact sheet, you may check with some of the popular websites, where such data would be available.

Caution: Both these numbers are calculated for the past, and hence they may change over time. Having said that, these still are good indicators to compare different schemes.

Investors, who are risk takers, may prefer schemes with higher standard deviation or schemes with Beta above 1. On the other hand, conservative investors may look for schemes with lower standard deviation or those with Beta less than 1.

Choose your schemes wisely.

-        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.

Does SIP have any limitations?

My article in Mid-day Mumbai edition today. Click on the link below to read:

http://epaper.gujaratimidday.com//epaperpdf/gmd/30112015/30112015-md-gm-10.pdf



Th English translation is as under:

Very often people ask this question, “So many financial advisors keep talking so many good things about SIP. Is there anything negative about it?” Come to think of it. Can there be something that is only good and without any limitation?

Well, SIP is not without any limitations. It has two serious limitations.

(1) That the asset prices have to go up in the long term, and

(2) During the investment period, even when the market is at a high level the investor keeps investing (though one buys fewer units)

Well, some may argue that these limitations are not very serious or that these are no limitations at all. Even if someone believes so, let us look at the word “limitation” with an objective to explore if there could be something better.

Incidentally, there is, at least in theory.

Let us look at the second of the limitations we have highlighted, that in SIP, we keep investing even when the markets are at high levels. The advocates of SIP would argue: Is it possible to know in advance if the markets are high or low? And since we do not know in advance, we keep investing and the principle of “Rupee Cost Averaging” takes over.

This principle of Rupee Cost Averaging helps us reduce the cost of purchase. When we invest a fixed sum of money in equity mutual funds, which have volatile NAVs, we buy more units when the NAV is low and fewer when the NAV is high. This happens automatically since the units allotted are a function of the amount invested divided by the prevailing NAV. This, by itself, turns the stock market’s inherent volatility do work for the investor.

However the fact remains, even though one buys fewer units, one does buy something even at market peaks. Let us see if at market peaks we can stop our investments or even take some money out of the investments.

Michael Edleson, a former professor at Harvard Business School promoted an approach that can improve upon the SIP. This approach does not keep the investment amount constant, but changes it – either the amount is increased or decreased. Incidentally, the investment amount is increased when the markets are low and vice versa. This approach is popularly known as “Value averaging”.

While in case of SIP, the regular investment is kept constant, in value averaging, the attempt is to keep the monthly (or whatever period one has chosen) value constant. As we all know, the value of investments (NAV of an equity mutual fund) would regularly change in line with the movement in the market prices. When this happens, the fresh investment amount would be adjusted such that the value is restored to a predecided level. We will continue with the discussion and also use illustrations in the next issue ...

-        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.