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Asset Allocation

The In-active Asset Allocation Model

For a long time now, I have been updating a simple Asset Allocation Model here. This model which has a large weight towards Time and Value is designed primarily for Active Investors who would like to reduce risks when markets look frothy and add to exposure when blood is on the streets.

Most asset allocation models advise one to re-balance once a year or even once every 2 years since every re-balancing results in churn which can turn out to be expensive in the long run. The problem is that longer time differential between allocation re-balancing, higher could be loss of opportunities that present themselves.

For instance, when markets tanked in February it provided for a very small period of time a opportunity to snap up stocks / funds at a extremely undervalued (relatively) level. This kind of alacrity is what results in Alpha over the long run.

But the above model may not be suitable for someone who is starting of today and is saving for the very long term, for example Retirement. The aggressive model is currently at  30 : 70 in favor of debt and while this in a way signifies that there is Risk of a draw-down / lower returns going forward, this may not be a big issue for a investor who has saved very little, but wants to deploy small amounts regularly over time.

The United States is where one has seen all kinds of financial innovation and its there that the idea laid out below comes from.

Lets take the case of Dilip who is 25 years old, works for a private company and wants to save for retirement. Historically the easiest and the most efficient way to save on taxes while also saving for Retirement was through Employee Provident Fund. Even today, for most employees, that is the biggest savings kitty since the concept is kind of forced on them and most don’t see reasons to disturb the growing nest.

In the early 1990’s, Donald Luskin and Larry Tint[2] of Wells Fargo Investment Advisors invented what is known as “Target Dated Funds”. Target Dated Funds use the same Funds as anyone else but offer a glide path that reduces exposure to equities as the end date approaches.

Today, fund houses from Blackrock to Vanguard offer Target Date Fund with maturity extending to the year 2060. The further the time period, higher is the equity portion of the allocation matrix.

Here is the split between Debt and Equity for various end dates in funds managed by Vanguard

As can be seen, as the year of Retirement gets closer, the allocation to equity as percentage of total portfolio falls significantly. This tapering of equity exposure lowers the risk for the investor who is close to retiring and looking at the fund to be part of his annuity scheme.

Investors in India are yet to see funds like above being launched and hence there is no automatic way to save with a variable asset allocation that is linked not to markets as most Balanced / Hybrid funds available today are, but instead linked to one’s own target year.

But creating such a fund for one’s own purpose is very easy. All you need to do is select a couple of mutual funds (1 Large Cap, 1 Mid Cap and 1 Small Cap) and a Debt Fund (either Ultra Short Term Fund if Retirement is close by or Gilt funds if Retirement is far away).

What would be the choice of funds for someone like Dilip?

Given that he has a minimum of 35 years before he retires, his asset allocation mix would replicate the 2055 fund. 90% of his savings should go towards equity fund while the rest 10% can be allocated to debt funds.

Gilt or Ultra Short Term Funds

The choice of which fund to invest primarily lies with whether we believe interest rates will harden from hereon, in which case Ultra Short Term funds make sense or interest rates will soften further. In case of the later, Gilt funds allow one to lock up on the interest rate that is currently available.

Since Dilip is looking to save for the long term with a very small allocation to Debt, Gilt funds make sense for him given that Interest Rates are generally hiked when economy turns better and if happens, thanks to his 90% exposure to equity, loss (notional) in Gilt funds will be more than made up.

Mutual Funds or ETF’s

For the Equity Exposure, long term readers would know that I am a strong proponent of ETF’s and yet there is ample data to showcase that even though ETF’s make a whole lot of sense in US, its not the same out here. Indian markets continue to provide opportunities for Alpha though given the time frame we are looking at, its undeniable that the sky will be as clear in 2050 as its today.

Exposure by Category:

How much of the portfolio should be comprised of Large Cap Funds?

Lets first look at the performance of various indices.

Starting from 2004, we can observe that the best performance has been delivered by Nifty Midcap 100 Index. Worst performance is by Nifty 50. But this picture suffers the starting point bias, what if we started at the peak of 2008?

Suddenly, Nifty 50 doesn’t look so bad and Nifty Mid Cap isn’t a winner, let alone by a distance as could be seen in the first chart.

Based on a simplistic idea of adjusting total returns by the risk (measured in terms of Standard Deviation of Monthly Returns), I came up with the following allocation matrix.

Remember, this is more of a Guide than a Advise. The thought process is to participate without risking great damage when the correction finally shall set in.

Instrument of Choice

Large Cap:

ETF: Nifty Bees

Mutual Fund: Quantum Long Term Equity Fund

Nifty Next 50:

ETF: SBI ETF Nifty Next 50 Fund

Index Fund: ICICI Prudential Nifty Next 50 Index Fund

Nifty Midcap 100:

ETF: Motilal Oswal MOSt Shares M100 ETF Fund

Nifty Smallcap 100:

No ETF’s exist for the Small Cap 100 Index. Neither do we have any Index Fund.

Mutual Funds: Sundaram S.M.I.L.E. Fund, Franklin India Smaller Companies Fund & L&T Midcap Fund are the current best among the crop based on 10 year returns.

Ultra Short Fund:

On a 10 year look-back, Birla Sun Life Savings Fund, ICICI Prudential Flexible Income Plan & UTI Treasury Advantage Fund – Institutional Plan are the best in business.

Do note, much of the Analysis is based on historical data. The future may not be exactly similar and funds that are leaders today may make for laggards tomorrow. But given that historical data is all we have, I believe one needs to make the max of it using principles that have proven historically.

Hope that if nothing else, this post provides you food for thought on how to save for Retirement or for any other time based goal you may want to save for.

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