What is asset allocation?
Asset allocation is the process of allocating capital of an investor across asset classes. Allocation in each asset class is generally based on the risk profile / return expectation of an investor. For instance: A balanced investor could have 50% of his savings in equities, 35% in debt and 15% in gold.
Why asset allocation?
Empirical research shows that more than 80% of the returns are made through right choice of asset allocation. This is very difficult and even the smartest individuals in the world are not able to do it successfully over time. Ideally, every investor wants lower risk and maximum return. This is not possible as there is always a trade-off between risk and return.
Asset allocation should help an investor in achieving maximum return for a given level of risk. For example: For a pure equity investor, if you add other asset classes, risk-return profile of the investor would increase significantly.
Some people have misconception that lower risk actually means lower returns. This is not necessarily true. For instance: Equity markets in India have not given any returns since 2007, while debt has given 6%-10% returns year on year. So, a balanced fund investor—by taking lower risk—would have outperformed the equity investor, who took higher risk.
How to do asset allocation?
Asset allocation requires some basic framework to follow. It could be thumb rules or quantitative analysis. Generally, an investor would need the investible asset classes available, their historical & future returns, risk profile, expenses and tax structures.
After determining risk / return profile of asset classes, asset allocation strategy needs to fit to an investor’s risk profile. For a given risk profile, there will be only one optimum asset allocation. The process would need to be run at periodic intervals as return profile of asset classes could change or risk / return requirement of investor could have changed.
Challenges of asset allocation execution:
There are many challenges in executing an asset allocation. A few common ones I am outlining below:
Costs & lock-ins: Some asset classes are available but their costs are very high. For instance: A private equity / real estate fund is available at fixed fee plus performance incentive. This fee—when compared with a normal mutual fund—is very high.
Taxes: All asset classes don’t attract same tax structure. Equity has a different tax structure than debt. In debt also, a fixed deposit, bond and debt mutual fund has different tax structure. While constructing and rebalancing a portfolio, taxes play very important role.
Lot size: Sometime the minimum investment requirement per security is high and the problem gets compounded when one wants to construct a diversified portfolio in an asset class. Let’s assume: In a mutual fund, minimum investment amount is Rs. 5,000. In a real estate fund, minimum investment could be Rs. 25 lakh. In a direct property investment, it could be at least Rs. 1 crore. So, if one wants to allocate 20% of the money to real estate, through real estate funds, one needs a minimum of Rs. 1.25 crore.
Manager selection: In each asset class, how to evaluate a manager if one is employing a third party manager, e.g. a mutual fund manager. There are more than 300 equity fund schemes available where to invest and how much is a big problem.
Monitoring: How to monitor the portfolio on a regular basis, especially if one has an illiquid security in the portfolio. For the listed security, there are options available which provide regular data feed / portfolio details.
A few common points to think about investing
How many investors would have allocated additional money to equities in October 2008 when the equity markets were at multi year low? How many investors saw double digit returns from income / gilt funds, from debt funds from October 2008 to December 2008?
So, what is the solution? The answer lies in a disciplined asset allocation across asset classes.
Quickest & lowest cost way for asset allocation
The solution lies with an asset allocation fund. An asset allocation fund is a fund in which a fund manager allocates money to various asset classes. This product could be a single manager fund or a multi manager fund.
What is a multi manager asset allocation fund?
In this, a fund manager chooses managers for an investor across asset classes, depending on the investment objective of the fund. In simple terms, in a multi manager fund, the investor hands over his decision to select managers to an expert, in return for a better performance of the portfolio vis a vis his own, over a medium to long term.
Multi manager types
Fund of fund: In this case, the expert will invest in a range of existing funds available on the market.
Manage the manager: In this case, the expert will appoint other managers / advisors to run different parts of the portfolio according to a specific mandate.
In India, fund of funds are popular and offered by various asset management companies.
Can an investor construct multi asset portfolio on his own?
Most investors can construct a portfolio of various asset classes on their own. They take inputs from various sources: advice from a financial advisor, a friend, surf the Internet, etc. However, in all such cases, the discretion to invest in a particular asset class or scheme remains with the customer and the portfolio performance is his own responsibility. In most cases, more true in case of retail investor, an investor would make a decision to invest in a particular asset class / scheme when the story is over.
With Indian economy getting globalised, an asset prices changing continuously—because of economic, political, social issues whether local or global—the portfolio construction and monitoring has become a specialised skill.
It is very important that an investor carefully chooses an investment advisor, discusses in detail his / her requirements and accordingly construct & monitor multi asset portfolio on regular basis.
Why investing does not mean only equity
Indian investor in general in a conversation would ask, “What is the right time to invest in markets?” He means equity markets. But, investing is not only about equities. Investing means asset allocation, manager selection, monitoring and regular review.
A few examples:
Over the last 10 years, gold has given almost similar returns as equities and is one of the asset classes where returns are positive year on year. Equities had underperformed in 2004, 2008, 2010 and 2011. Again, Indian debt funds have not given a single year negative returns in the last 10 years.
If an investor would have shifted money from equities to debt in 2007, his portfolio would be up by almost 40%-50%, compared to flat to negative returns if he did not change. A global high yield or a convertible fund would have given similar returns in 2009 as Indian equities, at far lower risk.
Has the perception of Indian investor changed towards equities?
It appears so as the inflow into other asset classes from investors have increased while equities have seen outflows. It could primarily be attributed to the fact that equities have given negative returns in the last few years while many asset classes have given positive returns.
What is the view on allocation to global asset classes?
Global asset classes should be part of an Indian investor’s portfolio. However, the challenge is the availability of investment options in local currency. There are a few feeders funds available from fund houses but most of them are either equity or pseudo equity, which means their risk-return profile is closely correlated to Indian equities.
Despite that, the local currency depreciation against US dollar would have benefited many such investors as Indian currency has lost almost 25% in last 15 months. Some of these funds have given significant positive returns compared to Indian equities which have given negative returns.
The author is EVP & head–multimanager investments at ING Investment Management, India Pvt Ltd.
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