Asset allocation to funds: Factors that shape portfolio performance

A rule-based approach in mutual fund investments will protect you from disappointment

In the quest for high returns, investors focus on picking the winning mutual funds and may overlook other pivotal elements that determine performance. Whether you are just starting out as an investor or looking to refine your strategy, understanding these variables is important.

Portfolio performance (good or bad) is a function of the following aspects: Asset allocation, market trajectory, investment trajectory, market timing, and choice of funds.

Asset allocation

What percentage of your portfolio was in stocks when the markets did well or badly? In my opinion, this is the biggest contributor to returns. Yet, it does not get enough attention. We are just keen to find the next best-performing mutual fund.

Then, what is the best or the most optimal asset allocation for you? The answer to this question depends on your risk profile and financial goals.

Personally, I prefer to make this rule-based and not tinker too much according to market outlook.

Why rule-based? Because we get affected by what’s happening around us. Investors tend to prefer riskier allocation (higher equity allocation) when the times are good. They start to believe that equities are not risky and they just have to hold them for the long term and everything will be fine. However, for most investors, a long-term investment is actually short term. When the times are bad, many investors turn conservative and want less risk in their portfolios.

With such an investment approach, you are only setting yourself up for disappointment.

While there is nothing wrong with wanting high returns, you must appreciate the chance of higher risk.

As an advisor, my experience of interacting with investors is that during good times they feel I am too conservative. During bad times they feel I am too aggressive.

A rule-based approach keeps emotions and biases in check, so choose an asset allocation that is appropriate to your risk profile and stick to it.

Market trajectory

You may have picked a good fund but at the wrong time or during (or just before) a bad market phase. Your returns experience in the fund may not be good, at least in the short term.

You may have picked a poor fund but at a good time or during (or just before) a good phase. The performance will appear good.

In your portfolio, Fund A may have done better than Fund B because the first one has gone through a good market phase and the other one has not. 

You cannot say that Fund A is better than Fund B simply because Fund A has given an XIRR (extended internal rate of return) of 11 per cent while Fund B has delivered an XIRR of 7 per cent. What if you had invested in these funds on different dates or during different periods?

Your return experience in a particular fund is also a function of when you started investing in that fund, when your investments went in (SIP), and when you are checking the performance.

Market trajectory is something that you cannot control.

Investment trajectory

How much did you invest when markets were struggling or booming? The market trajectory is the same for everyone but investors’ reactions to market conditions vary.

With the benefit of hindsight, if you look at past data, you can say that bad stock market phases are a great time to invest. While there is no guarantee that the past will repeat, history does tell us something about the nature of markets.

The question is: What do you do when markets are struggling? Do you sell or stop your SIPs? Or, stay disciplined, continue your SIPs, or even invest aggressively if your cash flows permit. How you respond to different market conditions will determine your returns.

Investors are more comfortable investing aggressively when the markets are booming, not so much when markets are struggling. Ideally, it should be the reverse.

This presents an interesting problem. Let’s say the markets are struggling and funds are not performing well. An obvious reaction is to stop or reduce investment. However, by doing that, you will let go of an opportunity to accumulate ownership at lower levels. This can be counter-productive over the long term.

If you continue to invest through a bad market phase and the markets recover subsequently, you will see good returns since you bought units at lower net asset values (NAVs) and averaged your purchase price down. Contrast this with a scenario where you stop investments during a bad market phase. Your purchase price will remain high.

It is true that luck plays a considerable part. No one knows upfront how long a testing market phase will last. This is when investment discipline counts.

Investors have control over investment trajectory, at least to some extent. Sometimes, investment trajectory is just a function of your investible surplus.

Market timing

Not many can pull off market timing. A rule-based approach will work better over the long term compared to a gut-based approach for most investors.

Choice of funds

This is where most of us spend the most amount of time. In my opinion, this is also the least rewarding step. For most investors, this activity usually does not translate to better returns.

Everyone wants to pick funds that will beat the market or benchmark by a wide margin. How many of us can do that? More importantly, how many of us can do that consistently? Don’t know about you but I can’t.

When you try to beat the market, there is a chance that you may underperform the market. You get some calls right while you get others wrong.

Plus, even right or wrong is not an objective assessment. What looks bad today may look very good after a few months or years.

Fund schemes, fund managers, and investment strategies keep coming in and going out of favour.

This is where cap-based index funds score over active funds or even factor-based products. You don’t have to worry about the choice of funds. There is no confusion and that translates into better investment discipline. You focus more on asset allocation and the investment trajectory.

The writer is a Sebi-registered investment advisor.