Investors should remain liquid amid volatile trading

The first rule of investing is not losing money. It's not always that markets replicate fundamentals though mean reversion happens, but that takes time. For instance, the current equity markets have remained bullish despite the soaring virus infections/deaths and the struggling economies across the world. The movements in the stock markets have been nothing short of jaw-dropping and spectacular, of late. The liquidity and fiscal measures are to offset the losses, but it's considered otherwise leading to soaring markets.

It's important for investors to understand that investing is a war requiring survival across multiple battles to reap the benefits. And to survive one has to remain liquid as the markets could stay irrational longer than one can stay solvent. Also, it's difficult to digest the value of our investment, though notional, to erode during the volatile periods. While it's vital to reduce the risk, one always aspires to gain from the market upticks that could be achieved through an asset allocation strategy. This could be achieved through the hybrid funds, though a sub-category exists with regards to the possible maximum allocation to equity stating them aggressive, balanced or conservative.

While such a static asset allocation of a portfolio is good from a strategic point of view, it needs a constant revision and attention to suit the dynamic nature of the markets. This is where the dynamic asset allocator funds come into play. These funds bring variation in the allocation to equity through various metrics and hence, not only try to participate in the market upside, but reduce the heartburn alleviating the volatility of the markets. Of course, the market offerings include fund-of-funds (FoF), where depending upon the defined metrics the invested fund is moved between an equity fund and a debt fund.

The range of indicators or parameters used to define the asset allocation among the equity and debt varies between the traditional P/E (price to equity) or P/B (price to book value) models to their own proprietary index that goes beyond the traditional metrics to include Market cap-to-GDP ratio, etc. Whatever be the methodology, the idea of these funds is to better risk adjusted returns by containing the risk especially during the times of volatility.

One such offering from the DSP stable is DSP Dynamic Asset Allocation Fund. This fund has a two-factor model, which includes both the fundamental analysis for stock selection and technical signals for small overlay to capture uptrend in equity markets. The equity allocation would range from as low as 20 per cent to a maximum of 90 per cent depending upon the average composite percentile score and the balanced is allocated to arbitrage and debt.

The valuation metric considered for this fund is equal weighted combination of P/E and P/B of Nifty-50 TRI (total return index). The fund uses a composite valuation score to determine the core equity allocation, which is the average of percentile scores of both P/E & P/B. The score has a range of 0-100 and the equity allocation would be at a maximum of 90 per cent if the score is up to 10, while at the other extreme of the score upwards of 80, the equity allocation would be at 20 per cent. So, in simple words, higher composite valuation score represents higher valuation of equity markets, thus lower allocation to equities in this model and vice versa.

Displaying this quality, the fund has reduced the equity allocations during the peak times of the equity markets in the past few quarters, while gradually increasing the allocation to equity during the recent volatility. The equity allocation moved swiftly from about 40 per cent since January 2020 to about 80 per cent in April and only to cut back to 70 per cent levels by May 2020. The current equity exposure is now in mid 60s. This has resulted in effective capital preservation by 15 per cent over Nifty-50 TRI during the same period and by about five per cent over the Crisil Hybrid 35+65 aggressive benchmark index.

The core equity allocation is mostly done through the fundamental factors, while the technical signals are used to capitalize on equity market upswings. This allows the investors to put on a kind of auto-mode in terms of asset allocation of their investment allowing for potential capital preservation during market drawdowns. The fund is combindly managed by two managers one specializing in equity markets with a mandate to seek capital appreciation plus income and the other an income seeking debt mandate.

The debt portion of the portfolio is predominantly composed of short-term fixed income instruments of AAA rated instruments. The fund invests in quality businesses and uses the market corrections to add them at lower prices. About 20-25 per cent of the equity allocation is used for tactical allocation with turnaround triggers, while the core is of structural themes. The core portion of equity is a diversified portfolio with no outsized weights and with a large cap bias.

One of the objectives of this fund is to enhance investment longevity, which is what I've mentioned at the beginning of the article i.e. about the need to survive in the market to make gains. An allocation of the fund, however, should be subject to the goals of the investor and risk profile of the investor. But this fund could find space across the spectrum of the investors with varying proportion.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)