You can't pick next yr's winner asset class, so build diversified portfolio

Give higher weight in your core portfolio to asset classes that offer greater stability

To be able to construct an all-weather portfolio that can survive different phases of the market cycle, one needs to view how various asset and sub-asset classes in India have behaved over a longer period. A periodic table of returns allows investors to do that.

Winner rotates

The first takeaway from this table is that the winner asset class keeps changing. “The performance of asset classes is influenced by factors like stage of the economic cycle, liquidity, investor sentiment, stage in interest-rate cycle, and so on,” says Nirav Karkera, head of research, Fisdom.

According to Vaibhav Porwal, co-founder, dezerv, “Bond prices are impacted more by a change in a company’s credit rating while stock prices are affected more by whether a company achieves its earnings target.”  

Arnav Pandya, founder, Moneyeduschool warns that investors shouldn’t get carried away by the past good performance of an asset class and begin chasing it.

Adds Arvind A Rao, certified financial planner and founder, Arvind Rao & Associates: “No one asset class can be said to be superior to the others. Each will shine at some points and underperform at others.”

Reversion to mean

While investors believe that the recent momentum witnessed in a high-performing asset class will continue, they would do better if they invested with the view that performance tends to mean-revert. An asset class that has done well in the recent past is more likely to underperform in the near future, and vice versa.

Degree of volatility varies

Some asset classes are more volatile. “The returns of small-cap funds have ranged from -17.8 per cent to 77.5 per cent over the past 10 years, while those of mid-cap funds have ranged from -11.6 per cent and 71.7 per cent. Returns of large-cap funds have oscillated less — between -1.5 per cent and 41.1 per cent,” says Porwal. Gold and 10-year gilt funds are also quite volatile.

Next, let us discuss the nature of a few key asset and sub-asset classes.

Large-cap funds

These funds invest in stocks that are industry leaders and have consistent and sustainable earnings. Their large balance sheets and asset sizes, rich cash flows, and sustainable margins allow them to weather downturns better.

“Large-caps rarely surprise investors with their performance. Their stock prices don't get impacted easily by capital inflows and outflows. Hence, their prices exhibit low volatility,” says Karkera.

Investors should enter large-cap funds with at least a five-year horizon.

Porwal says since most actively-managed large-cap funds fail to beat their benchmarks, investors should invest via index funds in them.  

Mid- and small-cap funds

Mid-cap funds display middle-of-the-road characteristics (with large-cap funds at one extreme and small-cap funds at the other). Investors should enter them with at least a seven-year horizon.

Small-cap funds invest in stocks having small market caps, which are highly sensitive to capital inflows and outflows. These companies are also less resilient during economic downturns. On the positive side, these stocks can increase their earnings rapidly on a smaller base.

Mid- and small-cap funds tend to beat large-cap funds during bull runs but decline more in bearish times.  

Conservative investors should have a 70:20:10 allocation in their equity portfolios to large-, mid- and small-cap funds. Aggressive investors with longer horizons may allocate more to mid- and small-cap funds.

Debt mutual funds

Debt funds provide stability to portfolios. “While an equity-only portfolio can provide higher returns over the long term, the investor’s experience in such a portfolio is likely to be more volatile. Having an allocation to debt funds ensures a smoother ride,” says Joydeep Sen, corporate trainer (debt markets) and author.

An investor’s allocation to debt funds may equal his age: A 40-year-old may allocate 40 per cent of his entire portfolio. Allocation can be tweaked around depending on horizon and risk appetite.

Investors should choose a debt fund category whose average duration matches their investment horizon.

Gold

Gold does well in times of adversity. Since it does well when equities are down, it hedges the portfolio. But gold doesn’t generate earnings or offer coupons. It has long cycles and can be volatile. Hence limit your investment to 10-15 per cent of the entire portfolio. Rao says investors should have at least an eight-year horizon in gold.

How to build an all-weather portfolio

Since it is impossible to predict which asset class will outperform in a given year, investors must build diversified portfolios.

“Equities will give good returns when the economy is doing well and earnings are growing, debt when rates are being cut, and gold during periods of adversity,” says Rahul Jain, president and head, Nuvama Wealth. Having allocation to all three asset classes will ensure at least one is performing at any point.   

Jain adds that investors should take their age and risk profile into consideration when deciding on their allocation to various asset classes. Those who are younger, have a higher risk appetite, and a longer investment horizon may allocate more to equities and less to debt, and vice versa. To handle the high volatility in equity, invest with a longer time horizon of 5-10 years. “Investing via the SIP mode will also help investors benefit from the volatility in equities,” says Jain.   

Rebalance the portfolio at least once a year, or at market extremes, to ensure it remains in sync with the target asset allocation. “When equities are nearing peak levels, move money from equities to debt, and in the opposite direction when equities are underperforming,” says Jain.