Decoding a decade and more: Here are the insights from your portfolio

In this article, we explore how three different portfolios with varying risk parameters—conservative (where the asset allocation is in the ratio of 65:25:10:0 in debt, equity, gold and international equity), moderate (45:40:10:5), and aggressive (25:60:5:10)—have performed over 10-15 years. To be sure, asset allocation is key to the performance of any portfolio. It involves distributing different asset classes in a portfolio based on an individual’s goals, risk tolerance, and investment horizon.

Over a 10-year period, the three portfolios generated CAGR, or compound annual growth rate, returns of 9.5%, 10.8%, and 12.5%, respectively. The standard deviation, a measure of portfolio volatility (higher values indicating greater risk), is higher as the risk goes up. The portfolios‘ maximum drawdown during the market correction in 2020 further illustrates this relationship—the conservative portfolio fell only by a third of what an aggressive portfolio did. The latter has also been least efficient in terms of risk-adjusted returns.

There have also been instances when a moderate asset allocation portfolio outperformed a high-risk aggressive portfolio, even when invested for the long-term. For example, during the period when the market hit its peak in 2008 to now, the aggressive portfolio delivered returns that were 90 basis points lower than the moderate portfolio. This doesn’t mean higher exposure to equity is bad.

Periodic rebalancing

Asset allocation depends on an individual’s preferences and risk tolerance. Yet, while investors with higher risk tolerance might appear to fare better, sticking with your chosen allocation ensures a smoother long-term investment experience, says Deepak Shenoy of Capitalmind.

To maintain the desired asset allocation of a portfolio, periodic rebalancing is necessary due to changes in asset values. However, most investors struggle with this because it often requires going against the herd mentality.

Vishal Dhawan, founder and CEO of Plan Ahead Wealth Advisors, explains, “the discipline of rebalancing is challenging because investors find it difficult to take money out of an outperforming asset class, which goes against the natural inclination to chase winners."

The downside of rebalancing is the tax implications. Selling assets that have appreciated over a certain period may trigger taxable gains. Our analysis takes into account annual rebalancing.

Investors can consider tax-efficient strategies such as tax harvesting and selling securities on a first-in, first-out (Fifo) basis to mitigate costs. Most securities have concessional capital gains treatment for holding them for longer periods.

To avoid tax implications, one of the options is to infuse fresh capital into the portfolio to align the overall corpus with the desired asset allocation, according to Vishal Chandiramani, chief operating officer at Trust Plutus. He adds, “over-optimization to achieve the desired asset allocation can come with a substantial tax cost."

Yet another tax-efficient way to invest across asset classes is through mutual funds (MFs) that invest in multiple assets. Selling holdings of a portfolio by a MF does not attract tax in the hands of investors.

Multi-asset MFs in India

There are two ways of rebalancing your portfolio. The first is static rebalancing, where you set a target allocation for each asset class and then periodically adjust your portfolio to get back to those targets, regardless of how each asset class is performing. For our analysis, we considered static rebalancing annually on April 30 of each year in the last 10-15 years.

The second is dynamic rebalancing, which is a bit more flexible. In this approach, asset allocation is decided based on market conditions. It involves investing more in an undervalued asset class and reducing exposure to an overvalued asset class over the investment period. Dynamic rebalancing requires more active management of a portfolio and is considered more effective, according to Nirav Karkera, head of research at Fisdom.

Balanced advantage funds and multi-asset allocation funds in India are two primary categories in the MF space that dynamically change asset allocation based on market conditions. Here, we have focused on the latter, which also has exposure to either gold or international equity asset class. As per Sebi’s categorization rules, multi-asset allocation funds are required to invest in a minimum of three asset classes with at least 10% allocation to each. The category includes funds from fund houses such as ICICI Pru, HDFC, Axis, UTI, Quant, and SBI, with an overall AUM (assets under management) of ₹29,268 crore as on April 30.

While these funds have exposure to three or four asset classes, most funds in the category have a gross equity exposure of over 65%. This categorizes them as equity funds for tax purposes, as capital gains tax on equity funds is lower than debt funds taxation. As on 30 April, five funds in this category have a net equity exposure (unhedged) of more than 65%. The benchmarks of these funds also indicate that the portfolios aim to achieve 65% of the equity index returns. (For a comprehensive graphic on this data, go to livemint.com) Karkera says, “in such cases, the portfolios have to be tilted towards equity as no other asset class can generate equity-like returns in the long run."

Karkera emphasizes that these funds are not primarily designed for downside protection as their focus is on generating efficient returns. Risk-adjusted return of a portfolio takes into account the level of risk taken in the portfolio. In our analysis, we considered the Sharpe ratio [(portfolio return - risk-free rate at 6%) / portfolio standard deviation] to calculate the risk-adjusted return; a higher Sharpe ratio is considered better.

For example, as shown in the accompanying graphic, conservative and moderate portfolios have a higher Sharpe ratio than an aggressive portfolio, which means that the former portfolios achieved a greater return per unit of risk taken.

An important point to consider before investing in multi-asset allocation funds is that “unless investment in a multi-asset allocation fund is a dominant part of your portfolio, it only solves the asset allocation aspect for a small portion of the overall corpus," adds Dhawan. It means that the rest of the portfolio has to be actively managed by the investor.

Mint take

Before investing in a multi-asset allocation fund, investors have to, apart from understanding the suitability of the product, decide whether they are willing to invest a large sum of the portfolio in a single category of a mutual fund as against individually buying into each asset class. For those who are not ready to do that, a better alternative is to invest in low-cost passive funds for each class to meet the desired asset allocation requirements. One can choose to rebalance annually, which is often considered a reasonable approach for most investors. As it is common for investors to make regular investments, rebalancing a portfolio by infusing fresh capital can be an alternative to selling and buying existing assets, which amounts to transaction costs and taxes.