The discussion on asset allocation so far has mainly focused on diversification between equities, balanced funds, fixed income, non-financial assets and to a lesser extent sectoral and large-cap versus mid/small capital funds within the equity space. To help investors understand the risk associated with a particular scheme, the regulators brought in the aptly named ‘Risk-o-Meter’. However, one must realize that while risk is important, it is not the only differentiating criterion for asset allocation.
Using an in-depth analysis of 2021 market performance from the prism of a quantitative trader, we intend to highlight the importance of recognizing style risk in one’s investment portfolio.
As a consequence, the next step will naturally be to focus on making proactive allocation decisions with respect to the same.
To be fair, some financial portals already classify fund offerings based on a metrics of market cap versus style exposure. However, this approach has not yet garnered enough mainstream attention.
What is Asset Allocation?
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Simply put, it is the allocation of an investor’s portfolio among several asset classes. To begin with, in order to make such a generalization, the first step is to define the asset classes.
Once defined, this information can be aggregated to determine an investor’s overall effective asset mix. If it does not suit the desired mix, suitable changes can be made.
How does the style fit into asset allocation decisions?
If we stick to allocation within equities, various research papers in developed markets and anecdotal evidence in our market have proved that most of the performance variation i.e. outperformance/underperformance can be largely attributed to three major dimensions Is –
1. Cap Exposure: Large / Mid / Small Cap
2. Sector Concentration / Diversification
3. Value vs. Growth
The third dimension can be extended to value, growth and quality in our markets. For example if we look at 2021, below is the performance of underlying styles over time.
Key findings from the long-term analysis include-
1. Apart from 2021, price experienced some volatile years
2. Quality was the outperforming style, particularly in the first half of the decade that declined in the second half
So what are the lessons?
This cyclically stylized performance is attributed, among other things, to the macro environment.
For example, growth has been shown to be beneficial during times of low volatility and a benign interest rate regime.
Conversely, the price is known to perform well during high volatility and rising interest rate environments.
However, for the retail investor, the cycle is tough over time and is like trying to time the markets. Instead, a better approach would be to be disciplined during the cycle.
Just as investors insist on allocating a percentage of their assets to equities, fixed income, etc., they should also evaluate the style exposure in their underlying funds, irrespective of market cap or sector bias. If not, they are at risk of over-representation of a particular style in their portfolio, as each of these styles goes through its own performance cycle.
Ultimately, these styles represent the basic building blocks of the investment philosophy and while they may experience out (under) performance over the long term, they will all continue to drive markets globally.
Karthik Kumar is the Portfolio Manager at Alternative Equities, Axis AMC.
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