Here's all you need to know about allocation ratio in your portfolio

The current equity market levels, at least at the index level of say Nifty or Sensex or other indices, are at or near all- time highs. Some investors are taking some money off the table i.e. booking partial profit, some investors are confident over a long-term investment horizon while some others are in a dilemma, what to do.

The whole issue is that nobody knows the future. The discussions in various publications and other forums centre around the fundamental and technical aspects of the market, valuation levels, investment horizon from now on, etc. Discussion on valuation level of the market, e.g. price to earnings ratio (PE ratio), price to book value (PB ratio), etc. is relevant. Well, let us look at very simple, easy to understand and easy to implement solutions to this dilemma.

There is an allocation ratio in your portfolio, to various asset classes e.g. equity, debt, gold etc. This allocation ratio is decided by the financial planner after considering various aspects like risk-return profile of the asset class, objectives and financial goals of the investor, investment horizon, etc. This allocation ratio is not something to be considered only for the initial construction of the portfolio, but it is a very powerful tool for review and rebalancing of your portfolio. It leads to discipline by correcting aberrations in the portfolio’s effective allocation due to fluctuations in the market. Let us take a very simple illustration.

Let us say, you have decided a ratio of 60:40 between equity and debt in your portfolio. There is a 40% market correction from January 2020 to March 2020. Post the market correction, the value of equity in your portfolio drops and the ratio between equity and debt becomes 40:60. As long as you are sure of your long-term horizon, in March 2020, you would have purchased equity at lower prices rather than selling at a loss, provided you follow the discipline.

Similarly, now, post the market rally, when you are reviewing your portfolio and the equity component is significantly higher than 60%, you would book some profits. This is more of an illustration and depends on a case-to-case basis. If you are young and have a long horizon ahead, you can live with an equity allocation higher than initially thought of. If you are in the distribution phase of life (post retirement) or consolidation phase of life (5 to 10 years prior to retirement) you can book some profits and bring the ratio back to your desired level.

The whole idea is to say that this approach is not about the external aspects which are not in your control e.g. market valuation but about what is in your control i.e. your investment portfolio.

There is another approach towards this uncertainty of allocation to equity in the current elevated market levels. There is a category of hybrid fund called Dynamic Asset Allocation or Balanced Advantage Fund (BAF). Funds in this category have an apparent allocation to equity and an “effective” lower allocation decided by the fund manager, within the mandate of the fund. Let us understand how it works.

A BAF fund has majority of the portfolio exposure to equity, at least more than 65%, to be eligible for equity taxation. The balance is invested in debt. In the equity component, while there is the ‘long’ exposure i.e. purchase of stocks in the portfolio, and there is a ‘short’ exposure where some of the stocks have been sold in the stock futures segment.

Let us say a BAF fund has a corpus of Rs 100. Of this, Rs 80 is in equity, referred to as the ‘long’ position earlier, and Rs 20 in debt. The fund manager is of the opinion that the equity market is richly valued and intends to reduce the effective equity exposure. Accordingly, he/she goes ‘short’ on say, half the equity exposure i.e. takes a sale position of Rs 40 in the stock futures market. The implication of the move is that equity price volatility, either favourable or unfavourable, is cancelled out for half of the equity exposure.

The fund has 80% long and 40% short exposure, hence 40% is the net long equity position. You would ask, how does that help? It helps in two ways. One, for the unfavourable volatility i.e. share prices coming down, you are protected; 50% in this example. Two, provided the fund manager’s calls are correct, the effective equity exposure (net of short position) is increased when equity valuations are attractive and the protection (i.e. short position or debt allocation) is increased when valuations are stretched. The concept is like driving speed; in good roads you increase the speed and in bumpy roads you go carefully.

The method followed by the various AMCs for modulating the effective equity exposure is varied, like the 80% – 40% example discussed above. The parameters used are Price to EPS, Price to Book Value, momentum, trend, volatility, dividend yield, earnings yield, market cap to GDP ratio, etc. Some AMCs have a more objective strategy where the output of the model followed by them, which is a combination of the factors mentioned above, decides the net equity exposure.

In some AMCs, it is a fund manager-driven approach, where the fund manager decides the effective equity exposure on his/her reading of the market. Others will have a strategy combining objective (model-driven) and subjective (fund manager driven). For most of the funds in this category, the track record in the real sense is less than three years, since the implementation of the SEBI norms in early 2018. Some AMCs giving a longer track record have a repositioned fund since mid-2018.

The ones with a relatively long track record are: (1) ICICI Prudential BAF, which is the pioneer of the concept, modulates the effective equity exposure in the range of 30% to 80%, has inception date December 2006, 10-year return 12.95% annualised till 25 February 2021 (best in the category) and corpus size Rs 30,157 crore (highest in the category) (2) Franklin Dynamic Asset Allocation Fund has an inception date October 2003, is a Fund of Funds investing in FT Funds, but the AMC is going through corporate governance issues currently (3) DSP Dynamic Asset Allocation Fund with inception date February 2014, 5-year return is 10.88% annualised till 25 February, corpus size Rs 2,986 crore (4) Edelweiss BAF with 10-year return 11.22% annualised till February 25 and corpus size Rs 2,941 crore and (5) L&T BAF with 10-year return 11.39% annualised and corpus Rs 1,367 crore.

(The writer is a corporate trainer (debt markets) and author)