If these two conditions are not fulfilled, there is no case for equities. Mere investment in equity index products or an average mutual fund may not be enough to justify investing in equities. If index investing or a higher proportion in equity is to be justified, then:

Why go for equity?

Theoretically, the argument in favour of equities rests mainly on two factors:

— Their ability to beat inflation

— The negative correlation of their returns with those from debt

In India, the rate of inflation has over the past ten years been about 7 per cent. Returns from equity and debt have also been negatively correlated. Inclusion of equities would not, however, have been a rewarding experience because debt has provided significantly attractive returns, while equities have been marked by a high degree of volatility without commensurate returns.

Attractive, but history

Between 1994 and 2003, the one-year return from investing in debt has, on an average, been about 10 per cent. Between 1994 and 1999, the annual return for an investment held for five years was 10.8 per cent.

The returns adjusted for inflation too have been attractive. In terms of volatility, 95 per cent of annual returns fell in the 7-13 per cent range.

Going forward, the expected returns from debt are highly likely to move in a much narrower range — say, 6-9 per cent. Notwithstanding the rise in interest rates in 2004, double-digit returns from debt truly appear to be a thing of the past.

A crucial factor is the fate of small-savings schemes. A threat hangs over the continuation of the public provident fund. As the pressure of reining in the fiscal deficit mounts, the likelihood of administered rates on other small savings schemes being marked down sharply will increase. Returns adjusted for inflation that now range between 2 per cent and 3 per cent for long-term debt investments could fall to less than 2 per cent.

Equities, a chequered past

Even if returns from debt, adjusted for inflation, dip below 2 per cent, that does not automatically strengthen the case for equities. This is because of the poor performance of equity indices compounded by high volatility in returns. The annual returns of even top-performing mutual funds have been considerably volatile.

For instance, the average annual returns from BSE-100 ranged from a negative 40 per cent to a positive 90 per cent between 1994 and 2004. The average annual returns of a top mutual fund such as Franklin India Bluechip, too, have been between negative 26 per cent and positive 130 per cent during the same period.

The volatility of returns, however, narrows if the term for which investments are held is extended. The range narrows considerably when investments are held for five years. For five-year equity investments, the return volatility is less than four times that from debt.

For instance, for Bluechip, the average five-year returns narrow to 20-35 per cent per annum. The range is narrow even in the case of an average performer such as Morgan Stanley Growth Fund, at 7-15 per cent.

Good fund manager, a must

Only a skilled fund manager, however, can tap returns higher than debt. For instance, consider BSE-100, Morgan Stanley Growth Fund and Franklin India Bluechip. Compare the annual returns for a five-year period for investments made between 1994 and 1999.

The average premium over debt investment is negative for both BSE-100 and Morgan Stanley Growth Fund. In contrast, the average premium for Franklin India Bluechip is 15 per cent more than the returns from debt investment adjusted for inflation.

It is, therefore, not enough to stay invested in equities for longer; you must also select the right mutual fund. You may have to forget garnering the premium element in equity returns if you do not spend enough time choosing the right fund.

There are more than a handful of diversified equity funds, such as HDFC Top-200, Templeton India Growth, HSBC Equity and Franklin India Bluechip with an impressive record and dependable credentials. If you are, therefore, convinced of your ability to choose the right fund manager, then the long-term performance of the top mutual funds does translate into a stronger case for including equities in your portfolio.

Beneficial tax effects

We need to consider taxes too. Before 2003, the system of taxation did not unduly favour equities. Now, it does. Tax on gains from equities held for a longer term is almost negligible. In contrast, the incidence of tax on returns from debt could range between 10 per cent and 30 per cent. This has created conditions for higher returns from equity relative to debt than in the past for longer-term investments. For such investments, non-inclusion of equity not only reduces returns but also increases the risk.

How much to invest

What proportion of the portfolio should be allocated to equities? This depends on:

Expected returns from equity and debt

Expected volatility of returns

Correlation between equity and debt returns

Consider the following scenario:

Expected return from equity is 12 per cent

Expected return from debt is 7 per cent

Annual returns over a five-year period would be 0-24 per cent for equity

Annual returns over a five-year period would be 3-11 per cent for debt

In this scenario, allocation of 20 per cent to equities would be optimal. If, however, you expect higher returns of 15 per cent from equity and annual returns from equity over a five-year period to range from 5 per cent to 25 per cent, then a higher proportion of 30 per cent would be optimal.

A proportion higher than 30 per cent for equities is, however, not justified. If more than 30 per cent needs to be allocated into equities then volatility of returns from debt has to increase considerably from present levels.

That may happen only when the administered interest rates are reduced sharply and linked to market movements. Until such time, a dominant part of your long-term portfolio should remain invested in small-savings schemes.

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