The Hindu Business Line : The importance of asset allocation

AT "Funds World India 2004," a conference on mutual funds and alternative investment, fund houses blamed the high coupon rate on government relief bonds for the lack of investor interest in equity funds. The asset size of equity funds has risen just 2 percentage points since this April despite the sharp increase in stock prices. Fund houses indeed have a cause for concern. But it is preposterous to attribute the lack of investor interest to the high coupon bond.

Even if the Government were to offer a fixed coupon of 10 per cent, money can still flow into equity funds. For one, portfolio managers have to extol the virtues of asset allocation. For another, fund houses should take measures to improve the credibility of the industry.

Asset allocation: This refers to the allocation of investments across broad asset classes — stocks, bonds, real-estate, and so on. In his 1992 paper in the Journal of Portfolio Management, William Sharpe showed that asset allocation could explain more than 90 per cent of the variability in returns for a mutual fund. More recently, Ibbotson and Kaplan (Financial Analyst Journal, January/February 2000) showed that Sharpe's study holds good in the current regime.

If asset allocation is indeed important, fund-houses cannot really blame the government for offering high coupon risk-free bonds. For, whatever the returns on one asset class, it still pays to engage in asset allocation. This is particularly true for a portfolio containing government bonds and other fixed-income investments. Combining such a portfolio with stocks may be optimal because equity returns are unbounded on the upside.

So, if a portfolio manager is able to value-add to his investment style, portfolio returns could improve significantly. Index funds clocked a three-year return of 20 per cent-plus. Surely, an investor would have benefited by loading even 25 per cent of his portfolio with such funds. So, why then are equity funds not marketed as enriching portfolio value through an asset allocation process?

Portfolio alpha: Fund-houses are, perhaps, unsure if they can consistently deliver portfolio alpha. An earlier study by Business Line showed that active funds exhibited a high degree of correlation with the S&P CNX Nifty. This suggests that fund houses are primarily investing in stocks that move with the market.

The problem is that active funds have a high expense ratio and charge high loads that cut into the returns during market downturns. Active non-sector funds under-performed long-term gilt funds over a five-year investment horizon. Not adjusting for any survivorship bias, this fund universe, however, outperformed gilt funds by 30 percentage points over a one-year investment horizon. Such inconsistent performance, perhaps, does not lend itself to a good marketing experience.

The portfolio managers may, of course, argue that such inconsistent performance is a function of the investor behaviour. Investors buy more units if a fund performs well but redeem their investments if the fund lags its peer universe. To stem the redemption pressure, portfolio managers may be perhaps investing in large caps.

The point is that it is difficult for a fund to consistently generate portfolio alpha by merely taking exposure in large caps, especially the ones that constitute the index. Instead, fund-houses may do well to clearly define the investment style of each fund and benchmark the performance to the respective style index. That way, performance evaluation becomes transparent and marketing experience better.

Credibility: This factor cannot be overemphasised. Even if funds provide superior returns, investors have to be convinced about the credibility of the fund houses. Among other things, fund houses should desist from launching new products that are minor variants of existing ones. This may signal that the fund houses care more about investors than about asset management income.

Finally, investors should be educated about the importance of asset allocation. Perhaps then, money will flow into active funds. Otherwise, the scenario is unlikely to change, unless the government cuts coupon rates to less than 5 per cent. Even then, investors may flock to active funds out of necessity and not by choice.

(Feedback can be sent to bvenky@thehindu.co.in)

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