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.

Asset Allocation schemes - managed risk, enhanced returns

Some mutual fund houses have launched schemes known as the “asset allocation schemes”. What are these schemes? How do they operate? Should one consider investing in such schemes? 

Read my article in Mid-day Gujarati edition today on the subject of asset allocation ...

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The English translation of the same is as under:

Some mutual fund houses have launched schemes known as the “asset allocation schemes”. What are these schemes? How do they operate? Should one consider investing in such schemes?

Before answering the above questions, it is important to understand what asset allocation means. It is a process to allocate one’s investments across various asset categories. The reasons behind asset allocation, the reasons why and how much money is allocated to different asset categories could be either unique to the investor or sometimes based on the fund manager’s view on the opportunities in different asset categories.

Since mutual fund companies cannot customize the schemes for individual investors, the logic of investing the fund’s investments across asset categories cannot be done in line with the investors’ needs. Hence, the objective of the asset allocation schemes launched by mutual fund companies would be to generate better risk-adjusted returns. Some people call these schemes offer peace of mind to investors, as the returns are decent, but the price fluctuations are moderate.

For this purpose, money in the scheme is invested across more than one asset classes. Since the market prices of different assets move differently, the scheme’s NAV exhibits moderate movement only.

Let us assume that a scheme has invested in both equity and debt. As we all understand, market prices of equity and debt do not move together. At some time, when the equity prices could be down, debt might have gone up. This is when the down movement of equity would be compensated partly by the up movement of debt prices.

The reverse may also happen when the debt prices do not move much or move in negative direction, equity might be up.

Thus, the opposite movements tend to cancel each other out partly, which lowers the fluctuation in the NAV of the scheme.

The asset allocation schemes may allocate money across more asset categories. in the Indian mutual fund industry, we have schemes that invest in various combinations of equity, debt and gold.

In certain cases, the schemes define the allocation across the asset categories and keep the same fixed. So, a scheme may invest 60% in equity and 40% in debt. At a pre-defined frequency the allocation would be checked and if required, would be restored to the 60-40 ratio.

Some schemes may give some flexibility to the fund manager to alter the allocation marginally, based on his or her market view. Such schemes depend on the portfolio manager’s abilities to improve the scheme’s performance.

There are some schemes that allow changes to the set percentage allocation based on certain valuation parameters. We will talk about such schemes in our next article.

Till then, keep an eye on the asset allocation schemes. In fact, two categories of funds that we have already covered earlier are Balanced Funds and MIP (or Monthly Income Plans). These are also known as hybrid schemes.

One must be careful to check whether the allocation between equity and debt is fixed at a certain ratio or the fund manager has a leeway to change it as per the outlook. For this purpose, one needs to check the following:

1.     The Scheme Information Document (popularly known as the SID) contains the details of asset allocation allowed. Read the table as well as the text below it., and

2.     The fact sheet contains the details of actual investments made by the scheme. Even when the fund manager has the flexibility to change the asset allocation, more often, the same is not used and the allocation is kept fixed.

If the allocation is kept at a near-constant ratio, one is not so much dependent on the fund manager’s outlook on the different asset categories. However, when the fund manager keeps changing the allocation between equity and debt, it requires skills. These skills can add to the returns, but at the same time are subject to the risk of the fund manager’s judgment being wrong.

Happy investing to you all.

-        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.

Why mutual fund is the ideal investment vehicle for goal-oriented investing

If you know your financial goals and are planning to invest your money to achieve these goals, read this article first ..

Ideal investment vehicle for goal-oriented investing

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The English translation is as under:

Why mutual fund is the ideal investment vehicle for goal-oriented investing

A very important question all investors must consider before investing is: Why are they investing? What is the purpose of investing?

All the other questions are secondary to this one. This must be the first question that an investor must consider.

Let us understand the financial requirement of most of the middle class investors. Most of middle class people have certain large lumpsum expenses to incur in order to fund some major and important events in their life. These events could be having their own house, acquiring a vehicle, getting the children educated, marriage in the family and living a comfortable retired life. All these events require large sum of money, which may not be available when the event occurs. Money must be saved earlier in order to fund these events.

These are financial goals. Funding these financial goals is the primary purpose of saving and investing for most of middle class.

Once we understand that, the next question is how does one invest money. We have two options: invest your money in various avenues yourself or invest through mutual funds. We have discussed this in detail in some of our earlier articles.

There are some basic rules that one need to follow:

1.     Keep some money in short-term investments – these investments may not fetch high returns but the money would be safe here.

2.     Allocate your money in line with your unique situation – a process known as asset allocation.

3.     Periodically one needs to check how much is the deviation from the required asset allocation. This happens since different markets, viz., equity and debt markets behave differently from each other.

4.     Consider investing in equity if the goals are far in future. However, as the goal approaches near, the exposure to equity should be reduced.

It is really in points 2, 3 and 4 above that mutual funds become extremely convenient. First of all, allocating money across various asset categories is very easy if one uses mutual funds. At the same time, when one has to shift money from one scheme to another – be it from debt to equity or vice versa – mutual funds allow very convenient switching facility.

Mutual funds also have a major benefit in terms of availability of daily NAV, which allows one to regularly monitor if the current asset allocation is in line with the required one or has it deviated. Based on this, a decision regarding switch can be very easily taken.

All these switching can be done seamlessly within a fund house. The transaction is convenient as well as low cost. Mutual funds also are highly tax-efficient when it comes to such switches.

As against that, if one has built a portfolio by buying stocks and bonds, the big decision would be which stocks or bonds to sell and which ones to buy. In case of mutual funds, it is just a scheme that one needs to get out of or get into.

It is such high degree of convenience that majority of financial advisors also prefer to recommend mutual funds to their investors.

So, go ahead and take advantage of mutual funds in order to achieve your financial goals conveniently and comfortably.

-        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.