Aside from what’s happening in the market right now and the ongoing COVID pandemic in March 2020, investors have one question on their mind: “Where, from here?” Financial markets have been volatile since the pandemic hit economic activity last year. The S&P BSE Sensex fell to a multi-year low in March 2020, falling 37% since the beginning of 2020 and then rising nearly 2.4x by October 2021. The 10-year G-Sec yields have also been extremely volatile during this period, falling from 6.5% in January 2020 to 5.8% in May 2020; They have increased again to 6.3% in October 2021.
Today, when equity markets are at all-time highs and bond yields are said to have seen their lows, the question remains the same in investors’ minds. “Where, from here?” No one has the answer; But there is someone who can see you through the uncertainties of the market, your best friend in your investment journey- Asset Allocation.
While it is certain that the market will move upwards in the long term, it is also certain that the journey will not be entirely smooth. The market will be in a period of ups and downs, and you certainly don’t want these periods of volatility to eat away a large portion of your investments. Investing in asset classes like Equity, Debt, Gold etc. can help in diversifying your investments and thereby reduce the overall risk of the portfolio. The chart shows the average correlation between the three asset classes during the period from April 1, 2005 to October 2021.
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Low correlation implies that the correlation between the said asset classes is not strong and will likely not produce the same returns as the other over a given period of time. It is this disparity in performance that helps reduce risk in a portfolio because the weak performance of one asset class can be offset by relatively strong performance in another. Thus, the mix of asset classes will provide optimum risk adjusted returns. Chart 2 depicts the calendar year performance of the equity and debt indexes each, along with the returns of the 50/50 hybrid index. There are two ways to diversify your portfolio – DIY or do it yourself or rely on the expertise of professional fund managers. A proper asset allocation requires a deep understanding of all asset classes and the specific instruments within them. Tracking all market and economic parameters and adjusting portfolios can be a bit difficult as market dynamics change. In addition, rebalancing the portfolio to reflect optimal asset allocation will potentially incur various fees such as exit load, short- or long-term capital gains tax, and other transaction costs, as applicable. However, if you are not someone who tracks the market on a daily basis and is unaware of the specifics of each asset class, then another option is for you. By investing in hybrid funds, you can manage the asset allocation needs of your portfolio.
Hybrid funds invest in different asset classes. This diversification enables you to participate in the uptrend in rising markets and helps protect against downside in falling markets. In addition, the appropriate asset allocation mix based on market conditions is managed within the fund by the fund manager and does not attract any additional fees/costs/taxes.
The decision to invest in these funds should be based on your current portfolio, time frame and risk appetite. These funds invest a large portion of the portfolio in fixed income securities that offer stability and a smaller portion of the portfolio in equities that can provide opportunities for capital appreciation. Aggressive hybrid funds have a higher allocation to equities and a smaller portion is invested in fixed income securities. If you are comfortable with relatively high risk appetite and want to invest primarily in equities, then this could be the fund for you. Then there are dynamic asset allocation funds that have the freedom to change their asset allocation based on the fund managers’ perspective on the market. These funds increase exposure to equities when the market is showing signs of correction and reduce equity exposure when the market is expected to rally. This enables you to participate in market rally as well as have a cushion in times of market correction.
DP Singh is the Chief Business Officer of SBI Mutual Fund.
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