Financial Planning - An evolved way out for Asset Allocation

Personal finance revolves around asset allocation. Mix the right assets in the right proportion, and take diversified exposure in each asset class. Over the long term, this should fetch acceptable returns for acceptable risks.

It’s assumed that equity should, in the long run, deliver higher returns than other financial instruments and that compensates for the stock market’s extra volatility. It is also assumed that debt is safer, more stable than equity, hedges against a bad bear market, and offers fixed returns.

Fallacious assumptions

Is that second assumption about the nature of debt true? If a corporate chooses to default on a loan in India, legal recovery is very slow. In effect, Indian non-government debt is not as secure as is presumed.

In theoretical terms, real debt returns depend on inflation and currency stability. Both are volatile variables. Over the past 10 years inflation in India has ranged between 2 per cent and 13-14 per cent. Currency value has also swung a lot. So you don’t have assured real returns in debt.

If you are investing in debt across time frames and instruments, the only reasonable method is via debt mutual funds. Debt mutual portfolios are marked-to-market and inversely correlated with rate movements. If rates rise, a debt fund’s NAV drops. So there may not be even assured nominal returns if rates rise sharply. Such trends can occur over long periods.

So while the basic principles of asset allocation are sound, specific assumptions about safety and return need modification in an imperfect economy like India. Debt in India is more risky than is generally assumed, though admittedly safer than equity.

Many investors also see debt as a hedge against falling equity. But this is a fallacy, as pointed out above. Equity valuations usually fall if interest rates rise. But so does the value of debt. Both debt and equity give positive returns when interest rates fall. So there are long periods when debt and equity returns travel in the same direction. So the counter-cyclical hedging power of debt is limited.

Hence, higher equity weights may be sensible in an Indian environment because debt is relatively more risky than in First World economies. Of course, some allocation to debt is mandatory for any prudent individual.

The way out

But most investors should be willing to take higher equity exposures. One method of dynamic rebalancing could be to use the spread between earnings yield (the inverse of the PE ratio or Earnings/Price as a percentage) and the interest rate yield. Using a one-year fixed deposit rate or a 364-Day Treasury Bill Yield as the interest benchmark, we can compare it to the EP ratio.

A simple allocation rule would be: “If EP ratio is higher than T-Bill Yield, increase equity allocations. If EP ratio is lower than T-Bill yield, increase debt allocation.” This simple rule has worked well through the past decade or so.

It can be smoothed with checks on overall rate trends, and the differential amount. If the differential is large, signals are stronger. Historically since 2000, anybody who has gone overweight in equity in a disciplined fashion when the spread offers buy signals has made excess returns.

Several periods stand out. Between December 2002 and December 2005, the signal was continuously positive while the Nifty gained 200 per cent. Between October 2008 and January 2010, the signal was positive again while the market travelled up 72 per cent. Equally important, it kept equity allocations low during the big bear market of February 2000 to December 2003, when the index lost 40 per cent and again in the bear market of December 2007 to October 2008, as the market lost 60 per cent.

The 364-Day T-Bill seems like a good proxy for long-term returns. It is auctioned twice in the normal month, so there is a continuous flow of regular data points. T-Bill movements anticipate changes in fixed deposit rates. While these instruments are traded far more often by institutions than by individuals, they can be held by individuals. Of course, anyone building a PF portfolio could back-test other debt instruments and timeframes and may find more suitable benchmarks.

The basic point is that the individual should be aware that asset allocation cannot be done blindly following US-centric models. In a developing economy like India, debt is more dangerous than most people assume and the push towards equity should therefore be stronger.

source:valueresearchonline.com