The Hindu Business Line : Switch your asset allocation for better returns

The choice of investments for non-institutional investors is limited. These investors cannot take exposure through mutual funds or portfolio management schemes to alternative strategies such as private equity and hedge funds or even to asset classes such as commodities. This forces such investors to construct a portfolio consisting of traditional asset classes — stocks, bonds and at best, real estate.

However, the need to improve risk-adjusted returns makes it imperative for investors to take exposure to alternative strategies and asset classes. Here’s ‘reverse asset allocation’, a strategy that investors can employ to take such exposure.

Traditional asset allocation

Asset allocation refers to the process of allocating your investments between different asset classes. Traditional asset allocation refers to allocating assets primarily between stocks and bonds.

Most investors prefer equity for their core portfolio, adding bonds to reduce volatility and downside risk. With declining returns in the equity market and rising inflation levels, there is a danger that investors may not meet their objectives. Goals for an individual could be meeting child’s college education five years hence or buying a house three years from now.

Institutional investors such as pension funds and insurance companies face similar problems. These investors follow liability-driven investment — constructing portfolios to meet their liability structure. Their primary risk is that the portfolio returns may fall short of meeting the liability structure. These investors are, hence, taking exposure to alternative strategies and alternative asset classes to enhance returns.

Their asset allocation policy includes allocating assets to stocks, bonds, commodities and non-directional hedge funds. Their portfolio construction process is called the core-satellite approach. The core portfolio provides market or ‘beta’ exposure and the satellite portfolio strives to generate alpha returns — excess returns attributable to the manager’s skill. This column has, in the past, discussed various strategies that can be applied to construct such portfolio structures.

Reverse asset allocation

Some investors prefer to enhance their exposure to alpha generators (investments that outperform their class).

Such investors can apply a new concept called reverse asset allocation, where alpha generators constitute the core portfolio instead of the satellite portfolio. Stocks and bonds are added to this core to balance the overall portfolio risk.

There are some advantages in such ‘alpha-core’ structures. One, alternatives generate high structural alphas. This increases the likelihood of the cash flows from the portfolio meeting the liability structure. Two, alternatives such as commodities have low correlation with traditional asset classes. Using alternatives as the core portfolio, hence, increases the portfolio’s returns.

There are, however, certain issues that need to be addressed. Correlations do break-down under some circumstances. It is, hence, important to apply models that are robust; models that capture relationships even during market breakdowns. It is also important to contain the alpha-core exposure to not more than 60 per cent. The reason is that alternatives are less liquid than traditional asset classes. This means that alternatives cannot be relied upon to generate short-term income. It also pays to have sub-exposure caps such as not more than 10 per cent to commodity markets or market-neutral hedge funds. This will enable the portfolio to generate higher returns without being exposed to high concentration risk.

Regulatory issues

Alpha-core portfolios are not available for investors either through mutual funds or through portfolio managers. The reason is that asset management firms are legally restricted from taking exposure to alternative assets and strategies.

Currently, investors have to personally construct such alpha-core portfolios with the help of their portfolio advisors. This poses problems for small investors. Alternatives require large capital outlay and may be beyond the reach of most investors. Exposure to private equity as a general partner, for instance, requires at least Rs 25 lakh investible capital. And an alpha-core portfolio should have more than one such exposure to diversify risk.

It is, hence, important that investors are provided collective investment vehicles to enable exposure to such structures. The problem, however, is the associated risks. Private equity and hedge funds are high-risk high-return structures. That is one of the reasons why hedge funds investments are only available for HNIs and institutional investors.

Rather than restrict exposure to alternatives, SEBI would do well to educate investors about the associated risks and enable them to make discerning investment choices. It is not as if investors have not suffered huge losses on the mutual fund portfolios. Of course, SEBI and the market participants have to frame policies such as computation of NAVs before these structures hit the market. There is an urgent need to offer such products. SEBI should hasten the process to introduce to such products sooner.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)