Equity vs debt: What’s the best asset allocation strategy in bull and bear markets?

In the dynamic world of investing, market cycles are inevitable. From economic booms to downturns, bull runs to bear markets, navigating these cycles requires more than just patience. It demands a well-thought-out strategy that evolves with the times. One of the most critical aspects of portfolio management is having the right equity, debt and gold allocation, real estate being another. Each asset class needs to be approached very differently, strategically and tactically, given the unique characteristics of each asset class.

Equity allocation: Agility with risk-aware diversification

Equity investments inherently carry higher risk but also the potential for superior long-term returns. In changing market cycles, how you manage this component can significantly influence your overall portfolio performance, return and risk-wise.

1. Diversify beyond labels

Investors should focus on diversified equity funds with low portfolio and sectoral overlap. Well diversified portfolios minimise the adverse impact of sector rotations—a common phenomenon during economic transitions where outperforming sectors rotate. Once the ideal Equity allocation is decided, a lot of other subjectivities come into play. An Equity portfolio which has only largecaps is completely different from another which is mid and small-cap heavy. So allocation between large , mid and smallcaps also needs to be suited to your risk profile.

Sectoral funds are not a fit for most investors except those who have a high risk profile. Holding Sectoral Funds necessitates proper timing, and timing by itself is a high-risk trait in Equity investing. Sectoral funds do well only in certain pockets of time when the sector’s prospects are bright and even in that phase you may have to time the entry and most importantly the exit well to capitalize the opportunity optimally. Otherwise, it will pain you with a higher risk than a diversified fund and fall way below the returns of diversified funds.

Other than those with a high risk profile, the rest can avoid direct equities and resort to the mutual fund route as they are easy to manage and relatively less risky compared to portfolios built without expertise.

A smart equity portfolio can include:

• Multicap/flexicap funds – Offer the flexibility to navigate between market capitalisations. One needs to bear in mind that Multicap funds allocate a minimum of 25% each to large, mid and smallcaps. But Flexicap Funds of most AMCs, hold 50 or more in largecaps. So “flexi” in the name may not be truly followed by the scheme.
• Growth, value, and momentum funds – Each scheme may follow a different investment style among these 3. Each follows a distinct style and behaves differently in various market phases, and has different risk and return attributes. A combination of schemes that follow these different styles provides style-based diversification.
• Funds with tactical cash allocation – Certain funds are known to hold higher cash during volatile times. These funds can act as a cushion during market downturns. Schemes that avoid cash positions may capitalise bull phases well while schemes with cash high positions can limit the downside in bear phases.
• Limiting risk in smallcap & midcap funds – Midcap and smallcap schemes are riskier than largecap options, although they can offer higher returns. Nonetheless, there are strategies to mitigate risks within these categories, especially for Smallcap Funds. Since all stocks ranked beyond the 250th position by market capitalization are classified as smallcaps, the selection is quite vast. It is advisable to choose multiple smallcap schemes that feature distinctly different holdings. A broader diversification is suitable for Smallcap investments, so when selecting consistently performing schemes, one should look for those that comprise a higher number of stocks with lower individual stock exposure. For instance, schemes like Nippon Smallcap and Bandhan Smallcap include nearly 300 stocks in their portfolios, which aids in reducing overall risk.

2. Don’t ignore global diversification

Global equities provide a hedge against local market risks and currency depreciation. Allocating 10–20% of the equity portfolio to international funds can enhance diversification. Rebalance the global equity exposure periodically to take advantage of the relative outperformance of different geographies and themes.

The broader strategy for equity allocation

Once an equity portfolio is constructed on the foundation of a risk profile, you cannot change the position of the bricks based on market scenarios. Toggling within the large, mid and Smallcap exposure based on market cap rotation is a dangerous play. As a change in market scenario in no way alters your risk profile, you cannot do this shuffle. Do not allow your gut to spoil your portfolio’s risk attribute, as it may negatively impact the returns too. If you have sizable participation through SIPs use that to build your Small and Midcap allocation as high risk assets ride the volatility to full advantage through SIPs.

Debt allocation: Stability, but strategy-dependent

Debt investments aim to provide capital preservation and income, but their effectiveness varies significantly across interest rate cycles. While often seen as the “safer” leg, active management is essential.

1. Align with interest rate cycles

• Rising interest rates: During rate hikes, the market value of existing bonds drops. Hence, when interest rates are on the upward trajectory or at the peak, for long horizon investments it’s safer to prefer fixed deposits and for shorter horizons money market funds and short duration funds which are less sensitive to rate movements can be opted.
• Falling interest rates: When the interest rate cycle turns downwards, long duration debt funds can offer capital gains due to the inverse relationship between interest rates and bond prices.
• Stable/low rate environment: When rates are expected to remain stable, focus on short-duration funds. These offer reasonable returns with lower interest rate risk.

2. Tax-efficient alternatives for high-tax paying investors

For investors in the higher tax brackets, income + arbitrage hybrid funds (also known as debt plus arbitrage funds) offer better post-tax returns compared to FDs, especially in a softening interest rate environment. In a softening interest rate environment, the gross returns from these funds are likely to be equal or better than FDs, but the real arbitrage is in the post tax returns. The long term capital gains tax post 2 years is only 12.5% for these schemes vs upwards of 30% in the case of FDs for those in the highest tax bracket.

Add hybrid & non-correlated asset

A portion of the debt allocation can be packed within hybrid fund categories as they are tax-efficient. Long term capital gains tax of hybrid funds with over 35% and less than 65% equity exposure is 12.5% after 2 years. In the case of funds with 65% or more exposure to equity, the long term capital gains tax is 12.5% after 1 year. This is almost one third of the tax liability for a person in the highest tax bracket as compared to investing in pure debt funds or fixed deposits.

• Aggressive hybrid funds – These schemes hold more than 65% in core Equities and the remaining in debt.
• Dynamic asset allocation or balanced advantage funds – These help reduce volatility by automatically adjusting equity(with a mix of core equity and arbitrage) and debt based on market conditions. The debt exposure in most of these schemes is under 35%
• Conservative hybrid funds - These combine debt with a small portion of equity, offering slightly higher returns with controlled volatility. These funds typically hold about 25% in Equity and the balance in debt
• Multi asset funds - They give the highest spread of asset classes across mutual fund categories. They invest in domestic equities, debt, gold, silver, other commodities, REITs, invits and foreign equities. However, various schemes pick and choose among these asset classes and in varied proportions.

It's tricky to choose the most suited schemes from the above categories as within the categories each scheme can be starkly different in the composition, risk and returns. You have to do your math right when allocating to hybrid funds to ensure your asset allocation balance.

Gold as a debt proxy

During bright phases of gold, it can become a proxy to debt to some extent. With geopolitical tensions and inflation trends favouring gold over the past few years, up to 15% of allocation can be moved to gold (via ETFs or gold funds) during bullish gold phases. During prolonged consolidation or correction phases of gold, reduce this exposure to about 5% and move the rest to debt.

Risk management: The silent guardian

A successful asset allocation strategy is incomplete without a strong risk management framework:

• Periodic review & rebalancing: Stick to your asset allocation targets. In euphoric equity markets, profits should be booked and reallocated to debt; during market crashes, consider topping up equities.
• Contingency planning: Keep a liquidity buffer—3 to 6 months’ expenses in ultra-short funds or savings—to avoid forced withdrawals, and withdraw investments at a loss for emergencies during equity downtrends.
• Minimise emotional investing: Asset allocation helps in taking emotion and biases out of investing. Stick to a strategy and avoid herd behaviour during market extremes.

Final words: Dynamic yet disciplined

Managing equity vs debt allocation is not a “set it and forget it” exercise. It’s a dynamic strategy, where equity demands style-based and sector-aware diversification, and debt requires interest-rate sensitive positioning. Use gold and global equities as balancing tools in your portfolio, and allow hybrid funds to smoothen volatility and tax efficiency.

In essence, understanding the objective of different asset classes and their behaviour across market cycles and tailoring your exposure accordingly can help investors stay on course toward long-term financial goals, with fewer shocks along the way.

Toying with the overall asset allocation or micro-asset allocation within the asset class can happen only when your risk profile changes and cannot be based on your gut. Over-confident use of intelligence to alter the ideal asset allocation can become hazardous. Your risk profile needs to be assessed once in 3 years and whenever there is a significant change in your financial status.

Do not get impatient during low, nil or negative return periods of an asset class and attempt to move the allocation to the performing asset class of that period as the purpose of having various asset classes in a portfolio is knowing that every asset class’s return is seasonal and each one performs well in different market cycles. Timing investments in any asset class is bad, and dismantling the asset allocation is worse.

As different parts of your body have different functions and no one part can do all the functions, each asset class has a different role in a portfolio, and all need to exist in the prescribed proportion at all points of time. Only when the allocation goes short or in excess does it need to be rebalanced.

Your allocation is your compass. Let it be your guide, not your gut.

V.Krishna Dassan, Director, Dhanavruksha Financial Services Pvt. Ltd.