Readymade asset allocation products - should investors use these?

The purpose of this post:

• Is NOT to compare between different types of funds.
• Is only to reinforce my point that asset allocation must be continued even if our moods change from extremely negative to very positive. It is my experience that you will get a better result sticking to an asset allocation
• Is to make a point that products offered by mutual funds should not be written off just because some on social media criticize. Study for yourself and drop or accept a product.

That said...

"The most important key to successful investing can be summed up in just two words-asset allocation." ~ Michael LeBoeuf. I’ve been tweeting on this often. I often receive DMs and messages on various funds which offer asset allocation and whether they will be useful for retail investors. More often queries come because investors affected by criticism of everything on twitter and unfortunately retail investors get carried with this and make stupid decisions. Having received too many queries, I give here, a small note and start by saying – Do not reject anything unless you have analysed it yourself or tried and found it not suitable. What is useless for others may be good for you!!!

A small note on 2 of the common asset allocation products offered by mutual funds: I answer actual queries received.

AGGRESIVE HYBRID FUNDS:

These funds are designed in such a way that you have > 65% in equity to get the status of an equity fund. More often than not we find that the equity:debt ratio is closer to 75:25. So for an aggressive equity:debt allocation – a static non changing allocation, these are available.

So, why invest in these?

If you want a static asset allocation of about 70:30 in equity:debt. The debt part will protect against very heavy drawdowns. This ensures automatic tax efficient rebalancing. That is, when equity markets rise, equity will be sold off and when equity markets fall, debt will reduced and equity part increased to maintain the asset allocation. In a bull market a 100% equity allocation will far outperform and we as investors get carried away and do not protect our portfolios. A March 2020 like drawdown teaches us great lessons.

Any precautions I should take?

YES!! Two very important points to note. First, I would go for a fund that predominantly invests in large caps. Adventurism into small and mid caps has hurt some funds. Second, be aware of the debt part of the portfolio – it should have familiar sounding high quality paper. Many avaiable funds do follow the above guidelines.

So, did these really protect in the recent steep fall in equity prices??

Good question. Many of these funds which follow the above rules did protect. At one time benchmark indices were down >30% from highs. Below is a graph of 3 funds compared to a Nifty 50 Fund. The point is NOT to compare performance, but a simple visual representation to show that having asset allocation will protect you when there are big drawdowns and your portfolio will end up doing better if you maintain discipline in asset allocation. March 2020 was an eye opener.

 

So, why so much criticism on social media?

The one really jarring note about these is that when markets boomed after demonetisation, these were missold as alternatives to FDs and bought for monthly or quarterly dividends. That IS NOT the reason to invest in these. Another issue is that some fund houses may not have the highest quality debt in their hybrid funds. Recently fund houses which transferred papers from their credit risk funds to their hybrid funds caused great concern and received criticism. Be aware of shenanigans.

Your final take?

As long as you consider the above points- look for a stable large cap based portfolio and quality debt, I believe these have a place in investor portfolios. Note, in a raging bull market, a portfolio of 100% equity will far out perform. But, markets move in cycles. And it is my conviction that asset allocation ensures a better outcome for your portfolio! How you do it is your call.

Final point – know why you are investing in these – NOT for a monthly dividend, but for maintaining a static, aggresive asset allocation. Remember, stick to funds investing in larger caps.

The other popular hybrid product fund houses offer:

Dynamic Equity funds:

Unlike the above Aggressive Hybrid Equity Funds, these as the name goes – dynamically shift the equity and debt portions. The equity position can fluctuate between 20% to 80% depending on the model used by the fund. These are also popularly known as Balanced Advantage Funds! These are much more conservative than the aggressive hybrid equity funds.

So how do these work?

I can write a full post on these, but in brief, based on either a valuation model or a trend following model, the equity part of the portfolio will dynamically change according to the market conditions. So, in the last few years, I have seen the equity part of some such schemes go from 20% to 65% or maybe more.

Any example of how equity levels changed in a fund?

Yes, I just saw some data put up by a fund house on how the equity allocation has changed dynamically at various NIFTY levels and the table is shared below

 

An interesting comment I received:

Some on social media emphasize that we should do our own allocation and talk down these. What should I do?

Answer: They have their own systems and ideas and even though brilliant, their methods may or may not be suitable to you. Try out your own model. AMCs offer a readymade dynamic model and have been true to their models in most cases. It is up to you to see if they work for you. If you are a conservative investor there may be a place for a type of product which can do unemotional investing – buying low when things are bad while selling high when things are good. And do this in disciplined manner over and over again. Or we have the other type of Dynamic Fund which consistently aims to maintain higher equity levels when markets are going up and vice versa. Try for yourself.

The below graph shows how they contained the drawdown in March.

 

By and large, these funds have served a conservative investor well. It is important to note that the return expectation from these funds should be tempered. With so much debt and arbitrage positions, they are by nature defensive. These are not alternatives to FDs and these too have been missold for monthly/quarterly dividends.

Caution!

When investing in these you have to ensure that the fund house follows it model. One large fund house has such a scheme and disregards dynamic rules and uses it as an aggressive fund. That has not protected investors.

 

There are other types of hybrid funds becoming popular – multi asset funds which have gained popularity after the run up in gold. More about these at some other time.

In conclusion, this fall in stock prices has showed us how essential it is to have an asset allocation. Not all will use readymade asset allocation models like the hybrid funds AMCs offer. However, you decide for yourself. What is important is that you look more deeply at asset allocation and use your own model or a readymade investment product.