Finance Investment Strategy Portfolio Management

Introduction to Asset Allocation – Part III

Guest Post – Tanumoy Hazra

Challenges of asset allocation execution:

There are many challenges in executing an asset allocation. A few common ones have been outlined below:

I) 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.

II) Taxes: All asset classes don’t attract same tax structure. Equity has a different tax structure than debt. And within debt, fixed deposits, bonds and debt mutual funds have different tax structures. While constructing and rebalancing a portfolio, tax plays a very important role.

III) Lot size: Sometimes 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.

IV) Manager selection: In each asset class, evaluating the manger in charge of the pooled investments (e.g. a mutual fund) is a challenge. There are more than 300 equity fund schemes available in the Indian Mutual Fund industry, to narrow down on the right manager and the amount of investment to be allotted in a challenge.

V) Monitoring: Regular monitoring of a portfolio, especially if one has an illiquid security is a difficult task, especially for a retail investor without access to sophisticated investment screening and monitoring tools.

The act of investing does not equate to just stocks…

An Indian investor in general in a conversation would ask, “What is the right time to invest in the markets?” Generally, she means the stock market. 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, her portfolio would be up by almost 40%-50%, compared to flat to negative returns if she did not make the change. A global high yield or a convertible fund would have given similar returns in 2009 as Indian equities, at far lower risk.

Factors that play an important part in determining an Investor’s Asset Allocation Strategy

There is no set formula for determining an asset allocation strategy that works for you. It is different for each individual investor. Your asset allocation strategy will largely depend on:

Risk tolerance: Your willingness to brave ups and downs of the market for more potential returns in the long-term. You may be happy with 25% returns but are you also willing to take a loss of 25% on your investments? You may be willing to take risk in a bull market, but your true risk tolerance may be tested in a bear market.  Time horizon: How long can you stay invested without withdrawing or selling your investments? Also how long do you expect or want your corpus to last?                                                                                                                                                                                    
Financial Objectives: What are your financial goals? Do you want to invest to improve your current lifestyle? Or you want to build a corpus for your children’s education, maintain the current lifestyle post retirement or buy a new house?                                                                     Liquidity needs: How much do you need each month to maintain your current standard of living? What are your present assets? Do you expect to spend a lot of money in the near future on marriage, education or a medical requirement?                                                                                                      

These are some of the important questions that can determine which asset classes will best reflect your risk tolerance and return objectives. These are the critical factors that can help you identify a successful asset allocation strategy.

The final part of this introductory series to Asset Allocation hits the nail on why one must consider the art of Asset Allocation at all in the first place and goes on to explain the different types of allocation for investors with varied risk appetites: Part IV.