Build diversified portfolio, don't chase the mirage of safe equity fund

There are three approaches investors may take as they decide their asset allocations

Lions don’t eat grass. Similarly, there are no equity funds that are not volatile (risky). Such investments are volatile; it is their nature.

You can tame a lion but still not make it eat grass. Through various strategies, you can reduce losses in the portfolio but can’t completely eliminate the risk of loss in equity products.

If you are looking for a less risky (less volatile) equity fund, stick to large-cap or multi-cap funds. However, large-cap funds are volatile too and you can lose money if the markets correct sharply.

There are indices that pick up the least volatile stocks (Nifty 100 Low Volatility 30 index, Nifty Low Volatility 50 and S&P BSE Low Volatility Index). You would expect these indices to be less volatile. It is indeed so, but only in relative terms. The Nifty lost 38 per cent in March 2020. The low-volatility indices lost approximately 30 per cent.

Funds, risk

There are hybrid funds, asset allocation funds, and balanced advantage funds (dynamic asset allocation funds). Such funds are marketed as less risky alternatives to equity funds. Many such funds have done well, but they do not reduce volatility. Such funds simply invest less in stocks.

There are a few ways to do that.

One, let us say large-cap stocks fall 30 per cent in a week. A fund invests only 60 per cent in large-cap stocks and keeps the remaining in government treasury bills. Since the fund had only 60 per cent in stocks, it will fall only 18 per cent. 

Two, these funds bring in different kinds of assets with lower correlation and thereby diversify their portfolios. So, when Indian stocks are not doing well, international or gold may do well.

Asset allocation funds and hybrid funds take these two approaches. However, even with diversification, you can only reduce the quantum of fall. 

Three, take an active call on asset allocation. Active calls are usually driven through proprietary models. The intent is to increase exposure to equities when the markets are expected to do well and decrease when it is otherwise. Dynamic asset allocation or balanced advantage funds take this approach.

Again, such funds do not eliminate the risk of loss. ICICI Prudential Balanced Advantage Fund, a leader in this category, lost over 25 per cent in March 2020. 

Reducing portfolio volatility

You can take three approaches. One, do not take exposure to risky assets and stick with the comfort of bank fixed deposits, Public Provident Fund, (PPF), Employee Provident Fund (EPF), etc. Risk-averse investors may follow this approach, but they might have to settle for low returns. They will have to invest more to achieve your goals.

Two, include different assets with lower correlation like domestic equities, international equity, gold, fixed income, or real estate investment trusts (REITs). The premise is that not all assets in the portfolio will struggle at the same time.

Three, pick up a fund that manages the asset allocation for you: balanced advantage, hybrid funds, and asset allocation funds.

With the first approach, the value of your portfolio will not go down. The two others can hurt you during bad market phases. Therefore, while diversification and active investment strategies can reduce volatility to some extent, these can’t eliminate it.

While structuring portfolios, I choose almost the same funds for all investors. In other words, both aggressive and conservative investors get the same funds. The difference lies in the asset allocation, which in turn depends on their risk appetite.

For an aggressive investor, the equity allocation may be, say, 60 per cent of the portfolio while debt allocation may be 40 per cent. For a conservative (or risk-averse) investor, the equity allocation may be, say, 30 per cent equity and 70 per cent debt allocation.

Therefore, focus on asset allocation in line with your risk appetite.

Don’t chase the mirage of safe equity funds. They do not exist.

(The writer is founder, PersonalFinancePlan, a Sebi-registered investment advisor (RIA))