Mastering money making

MARKET INSIGHT

Following a price-earnings based asset allocation strategy could give investors good returns over time. Here's an example.

Active investors focus on finding the best stocks. This can lead to missing the wood for the trees. In some phases of the business cycle, equity as a class is a poor investment. Investors who sensibly shift allocations between asset classes can outperform those who are consistently overweight in one class.

Asset allocation strategies lead naturally to the ‘Fund of Funds’ (FoF) approach. An FoF tweaks a portfolio of mutual funds to vary asset-class exposures. The Franklin Templeton Dynamic PE (FTDPE) ratio fund is a good example of a FoF. FTDPE returned 24 per cent compound annual growth rate (CAGR) over the past five years while the Nifty returned 25 per cent CAGR.

However, the FTDPE's risk-adjusted return is much better than most pure equity funds. During the bear market of 2008, (the only long bear market between 2004-2009) when the Nifty dropped by over 55 per cent, the FTDPE's maximum loss was 30.5 per cent. It also outperformed in the last 12 months. While the index has risen 22 per cent year-on-year since September 2008, FTDPE has risen 22.7 per cent (Category returns: 19.2 per cent) .

This FoF's strategy is mechanical, and follows from the mandate. Allocation is tied to the month-end Nifty PE ratio. If the Nifty PE is low, up to 100 per cent of assets can be parked in equity. As the PE ratio rises, equity exposure drops. When the PE is high, 100 per cent of assets can be in debt.

One constraint is that all equity investments are made in the Franklin India Bluechip Fund, while all debt investments are in the Templeton India Income Fund. Neither of these funds are themselves, exceptional. They offer average returns for their respective categories. Another issue - FoFs as a class, are more expensive than pure diversified equity funds.

Nevertheless, asset-allocation works as a strategy. The reason is that valuations like price-earnings (P/E) and historic returns are mean-reverting and normally-distributed. Over the long-term, stock markets trade close to the historical average P/E and deliver close to average historical returns. Knowing how normally-distributed data behaves, we have some predictability that leads to useful investment rules.

Since September 1999, the Nifty has a CAGR of 13.5 per cent, including periods of massive negative, and massive positive returns. The average 10-year P/E was 17.6, while the median P/E was 17.3, and the modal values, between 14-15. The standard deviation was 3.7.

The laws of normal distribution say valuations will swing between P/E 14-21 (within one standard deviation of average) 68 per cent of the time and between P/E 10-25 (two SDs of average) 95 per cent of the time. It follows that equity exposure should increase if the Nifty is trading at the low end of valuations and it should be pared down at the top end.

The FTDPE's asset allocation is disclosed every six months. In March 2008, equity allocation was 50 per cent when the P/E was 20.6. In March 2009, when the P/E was 14.3, over 90 per cent of assets were in equity. One assumes that at the September 2009 P/E of 22.6, debt exposure will be a lot more than equity.

The FTDPE may be a good investment. However, it has even greater utility in offering a basic model for mechanical P/E-based asset allocation strategies. An individual may well be able to beat the FTDPE by diversifying across a wider universe of funds and assets with a similar strategy.

There are several ways to tweak. One is by being more flexible in target investments. For example, the investor could focus on say, the three or five highest-scoring diversified equity and income funds or he could concentrate on mid-caps, which usually beat the Nifty during big bull markets.

There is also nothing to stop the investor diversifying beyond income funds, into currency futures, or commodities. Of course, every such diversification carries new risks. Number crunching would also be required to confirm return distributions in other assets, and get an estimate of risks, etc.

An examination of the FTDPE strategy also suggests that it may be time for cutbacks in equity exposure. This seems paradoxical since the economy has just started to revive. But it's clear that equity valuations are close to the historical red zone. To justify current valuations would require a massive bounce in earnings over the next 6-12 months.