Asset Allocation - Balancing Risk and Returns

Published On: 29-Sep-2020

Over last 20 years, there were three occasions where volatility in the capital market was at peak. On these occasions, there was a sharp fall followed by a sharp recovery in short period.

Historical Volatility

Over last 20 years, there were three occasions where volatility in the capital market was at peak. On these occasions, there was a sharp fall followed by a sharp recovery in short period.

Technology, Media and Telecoms (TMT) Bubble 2000

ASSET ALLOCATION – BALANCING RISK AND RETURNS

Global Financial Crisis (GFC) 2009

ASSET ALLOCATION – BALANCING RISK AND RETURNS

COVID-19

ASSET ALLOCATION – BALANCING RISK AND RETURNS

Source: Bloomberg, Index reference – Nifty 50

During these occasions, central banks took dovish stance with loose monetary policy. In India, 10-Yr G-sec yields moved from 12% in 1999 to 5% in 2003-2004, rising to 9% in 2013 and again declining to 5.9% in 2020. Gold prices increased from Rs.4, 400 /10gm in year 2000 to Rs.52,000 / 10 gm in 2020. Commodity prices have been volatile with oil fluctuating between $20/barrel to $150 /barrel in the last 20 years (2000-2020)

This kind of volatility in various asset classes can be nerve wrenching for the investors. It can cause damage to their portfolio in short to medium term.

How should the investor deal with such volatility in various asset classes? 

The only way to deal with violent volatility in the capital markets is to have balanced asset allocation which can reduce the short-term volatility without giving up too much return in the long term.

One strong reason to have exposure to various assets classes is that ‘winners rotate’. It is very difficult to predict winning asset class every year. All investment ‘Gurus’ give one investment advice “Don’t put all your eggs in one basket”. Depending on the risk appetite and investment horizon, investor can balance risk and reward by allocating investment in various assets classes such as equity, fixed income, gold and real estate. Asset allocation does not eliminate risk. But it can reduce exposure to extreme high and lows in performance.

Asset allocation is like building a ‘Champion Team’. Don’t you want to have Sehwag and Dravid in your team? On a seaming pitch, it is Dravid who is going play like a ‘wall’ and prevent the team score going too low. On a flat pitch, Sehwag who is going to score higher and faster. The champion team have both Sehwag and Dravid. In the high growth economic conditions, it’s the equity which will fetch higher returns. In low growth conditions, it is fixed income and Gold which would prevent extreme lows in the performance. 

Performance of various asset class in last 19 years

ASSET ALLOCATION – BALANCING RISK AND RETURNS

ASSET ALLOCATION – BALANCING RISK AND RETURNS

 Data period: 2001-2020, Source: Bloomberg

Returns are in CAGR – Compound Annual Growth Rate

**Assuming weights of 65% to Nifty 50, 25% to 10Yr Gsec and 10% to Gold

Rather than putting all eggs in one basket, it’s possible to reduce volatility in the performance without comprising much on returns. Historical data listed in the above table shows that portfolio consisting Equity (65%), G-Sec (25%) and Gold (10%) may deliver returns like that of equity but at a significantly lower volatility compared to that of equity.

Dynamic Asset Allocation

Different asset classes perform differently over period of times. As each asset class earns different return, it results in change in allocation percentage in the portfolio. This change may increase or decrease the overall risk of the portfolio. Hence it becomes necessary to buy or sell portion of portfolio to bring weight of each asset class to earlier levels. Portfolio rebalancing is carried out to prevent market from changing overall risk level of portfolio.

For Investor, most beneficial form of portfolio rebalancing is dynamic assets allocation. When applied in a discipline way over a period of time, dynamic asset allocation can provide various benefits to the investors namely

  1. Lower portfolio volatility

  2. Comparable long-term returns

  3. Fewer extreme negative outcomes

Valuation of broader market can be used as a trigger for dynamically changing asset allocation. Globally, valuation matrix such as P/B multiple, P/E multiple, Dividend yield are used to gauge the extent of market overvaluation and undervaluation. Relying on a single parameter may sometime lead to wrong conclusion about market valuations. It is safer to use combination of all three parameters in appropriate proportion to assess market overvaluation and undervaluation.

Whenever, equity markets starts looking expensive, it should act as trigger for rebalancing asset allocation. Investors should look to reduce equity allocation and increase debt allocation. Conditions such as high P/B multiple, high P/E multiple, low dividend yield indicate rough weather in the equity markets. In a swinging ball conditions, investors should be risk averse and bat like ‘Dravid’ with a straight bat and protect his wicket.

Likewise, when equity market starts looking relatively inexpensive, it should act as trigger for rebalancing asset allocation whereby investors should look to increase equity allocation and reduce debt allocation. In a condition such as low P/B multiple, low P/E multiple and high dividend yield, investors should look to increase risk in their portfolio and bat like ‘Sehwag’ to maximize score.

Best illustration of dynamic asset rebalancing using valuations as a trigger can be seen in              UTI Multi Asset Fund. Following chart and graph demonstrate the change in exposure to various asset classes in response to changes in equity market valuations.

ASSET ALLOCATION – BALANCING RISK AND RETURNS

ASSET ALLOCATION – BALANCING RISK AND RETURNS

In nutshell, asset allocation is like building winning team. Investors needs to have exposure to various asset classes similar to a champion cricket team which can include players like Dravid, Sehwag, Sachin and Sourav. Equity market conditions should act as trigger for dynamically rebalancing the asset allocation just like pitch condition decides whether ‘Dravid’ or ‘Sehwag’ should face more overs in cricket.

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UTI Multi Asset Fund - An open ended scheme investing in equity, debt & Gold ETFs

ASSET ALLOCATION – BALANCING RISK AND RETURNS

Author Bio

Sanjay Dongre
Mr. Sanjay Dongre is Executive Vice President and Sr Fund Manager – Equity at UTI AMC Ltd. He is a B.E. (Instrumentation) graduate from College of Engineering and a PGDM from IIM Calcutta. He has been with UTI AMC since 1994. He started as a Debt analyst acting as a support service for fund management activity. He also worked as Equity Research analyst covering wide range of corporate and industries. Subsequently he worked as Equity Dealer, which involved handling all the activities relating to secondary equity market operations. Prior to joining UTI he has worked with Reliance Petrochemicals Ltd. as an officer in-charge of the Instrumentation Department. In July 2000, he joined Equity fund management team and is currently working as Sr Fund Manager, Equity.