‘Asset allocation is like a fire extinguisher’

By Morningstar |  05-05-22 | 
People spend too much time selecting the right fund/stock and trying to time the market. Research has shown that the primary decision of how much to invest in equity, debt, and other asset classes is the main driver of the performance of a portfolio, over the long term. Kirtan Shah, Founder, Credence Wealth Advisors, talks about what goes into constructing a diversified portfolio.

During a bull run, people hardly talk about debt and gold. It is only during a volatile market that asset allocation comes into the limelight. How important is asset allocation while investing?

Asset allocation is like a fire extinguisher. Nobody uses it until fire catches. When one has 80:20 equity debt allocation and we are in a bull run, investors complain that the 20% allocation to debt is not making as much money as equity. It is only when the market falls, that the 20% allocation to debt and gold becomes a savior.

When the market is correcting, investors wait for further correction. Also, people tend to run out of cash when the opportunity strikes.

There are multiple types of asset allocation strategies like constant weight, tactical and dynamic. The type of asset allocation one adopts would depend on the risk profile, time horizon, and other factors. Personally, I follow a dynamic and tactical asset allocation strategy. I decrease my equity exposure by moving to debt/gold when valuations become expensive. Also, one could move to a value theme when markets run up.

Asset allocation typically skews towards equity during a bull run. Many first-time investors jump into equities in such times. What are the dangers of investing in only one asset class?

In the last 30 years of the market cycle, you would probably have five instances where your portfolio would have witnessed a crash of 30-60%. When you approach investors during a crash, they feel markets would fall further or don’t have the cash to invest. This is why that 30% allocation to cash and debt will help you buy when markets crash. Even having a 100% debt portfolio is not desirable. Investors won’t be able to beat inflation. Skewness to both equity and debt can be a problem.

Investors are looking at international diversification but there are too many options currently. How can investors add international funds as part of the asset allocation?

There are emerging and developed markets. The kind of growth we are seeing in India is unparalleled. So we don’t need to buy into another emerging market fund. If you want exposure to a particular theme like Electric Vehicle (EV), then one can look at specific funds. The cumulative return of the MSCI Europe market has been 3.5% over the last three years. The cumulative return of S&P has been 46% for the last three years. Around 40% of this S&P return was accounted for by Facebook (Meta), Amazon, Apple, Netflix, and Google (FAANG) stocks.

When you are looking at diversifying into developed economies, theme-based investing makes more sense because a large chunk of the return is generated by one theme. Of course, it is difficult to identify which sector would do well. So one could look at having exposure to a U.S. market which will add global diversification to your portfolio.

Isn’t it difficult to predict which theme would work? Even in India, we have too many thematic/sectoral funds. How do you pick such funds?

You have to do a lot of reading and research. A theme can come out of government policy, geopolitical developments, industry changes, and so on. For instance, globally, there has been a shift from diesel and petrol towards EV. India is now working on ethanol. Ethanol is a sub-section of the larger EV theme. If you have been tracking Budget and government commentary, there has been a huge push toward manufacturing in order to reduce reliance on imports. Real estate is another emerging theme currently. If you see the income versus house prices ratio, it is at the 20-year best. You have to keep an eye on what is happening around you.

When it comes to international investing, should one opt for active or passive funds?

Most investors find it difficult to understand the nuances of fund performance. It is typically done through fund of fund structure. So investors need to understand the international fund and the domestic FOF which channelise the money. If we are not able to understand the nuances of the market, passive makes more sense.

How important is downside protection when constructing a portfolio of different asset classes?

The first thing I look for while filtering funds is the downside protection ratio. If markets fall by 50%, you need a 100% upside to reach your initial investment. If you are able to protect the downside then your upside can be significantly higher than investing in a fund that falls more and rises more. I will prefer a fund that falls less during a downturn.

All fund managers run through a cycle. I have not come across a fund that has performed well every year. They follow a particular theme and that theme goes through a cycle. Whenever you feel market valuations are expensive, allocate new money to value-oriented funds. Reverse when the valuations are cheap. When you feel markets could rally, go for momentum, passive funds or growth-styled funds.

What role do valuations play when deciding your equity allocation?

There are some investors who are ready to buy good business at any valuation. But it is wise to buy them at reasonable valuations. Valuation is an important determinant in deciding equity valuation. It is applicable while deploying new as well as existing money. We believe value tends to do well when markets become expensive. The market valuations have been expensive for the last year. You would notice that growth funds have done well in 2021. On the other hand, Value Funds have done well despite being invested in Large Caps.

What is the major source of return for a portfolio – is it asset allocation or the right selection of stocks/funds?

From my interaction with fund managers, I have learned that a major part of the return is derived from getting your sector allocation right. If you get your sector allocation right, even an average stock would perform well. That said, there are some fund managers who give more emphasis to bottom-up stock selection. While selecting funds, we look at if the top three sectors where the fund is overweight are likely to do well. Nobody is consistent. Every fund goes through a cycle. No fund will remain popular for ten consecutive years. If you have a well-diversified portfolio consisting of Indian equities, international equities, debt, and gold, you will earing a decent risk-adjusted return rather than try to time the market.


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