One thing in common between what is happening in the markets right now and March 2020, other than the ongoing covid pandemic, is the question in the minds of investors: “Where from here?” Since economic activity was hit due to the pandemic last year, Financial markets have been volatile. The S&P BSE Sensex plunged to multi-year lows in March 2020, falling 37% since the start of 2020, then rose almost 2.4x in October 2021. The 10-year G-Sec yield during this period was also extremely volatile, falling to 5.8% in May 2020 from 6.5% in January 2020; they are up again to 6.3% in October 2021.
Today, when equity markets are at an all time high and bond yields are said to have bottomed out, the question that keeps coming back to investors’ minds is still the same. “Where from here?” No one has the answer to this question; but there is someone who can help you navigate the uncertainties of the market, your best friend in your investment journey: asset allocation.
While it is certain that the markets will have an uptrend in the long term, it is also certain that this journey will not be completely smooth. There will be periods of correction in the market, and you certainly don’t want those periods of volatility to eat up a large chunk of your investments. Invest in asset classes such as stocks, debt, gold, etc. can help diversify your investments and reduce overall portfolio risk. Figure 1 illustrates the average correlation between the three asset classes over the period from April 2005 to October 2021.
A low correlation implies that the relationship between said asset classes is not strong and is unlikely to produce the same returns as another over a given time period. It is this disparity in performance that helps mitigate risk in the portfolio, as the poor performance of one asset class could be offset by the relatively stronger performance of another. Thus, a combination of asset classes will provide optimal risk-adjusted returns. Chart 2 captures the calendar year performance of an equity and bond index as well as the returns of a 50/50 hybrid index. There are two ways to diversify your portfolio: the DIY or DIY route or relying on the expertise of professional fund managers. Appropriate asset allocation requires a thorough understanding of all asset classes and the specific instruments that flow from them. It can be a bit tricky to follow all market and economics parameters and adjust the portfolio as market dynamics change. In addition, rebalancing the portfolio to reflect the optimal asset allocation would potentially result in various charges such as exit charges, short or long term capital gains tax and other transaction costs, if applicable. However, if you are not someone who follows the market on a daily basis and is unaware of the nuances of each asset class, the second option is for you. You can manage the asset allocation needs of your portfolio by investing in hybrid funds.
Hybrid funds invest in different asset classes. This diversification allows you to participate in the rise in the event of a rise in the markets and to protect yourself against the fall in the event of a fall in the market. In addition, the appropriate allocation of asset allocation based on market conditions is managed within the fund by the fund manager and does not incur any additional fees / costs / taxes.
The decision to invest in these funds should be based on your current portfolio, your time horizon and your risk appetite. These funds invest a larger portion of the portfolio in fixed income securities offering stability and a smaller portion of the portfolio in stocks that may offer opportunities for capital appreciation. Aggressive hybrid funds have a higher allocation to equities and a small portion is invested in fixed income securities. If you are comfortable taking relatively higher risks and want to invest primarily in stocks, this fund may be for you. Then there are dynamic asset allocation funds that have the freedom to change their asset allocation based on the opinion of fund managers in the market. These funds tend to increase exposure to equities when markets are expected to rise and decrease exposure to equities when markets start showing signs of correcting. This allows you to participate in the market rally and have a cushion in the event of a market correction.
DP Singh is Chief Business Officer, SBI Mutual Fund.
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