Understanding Asset Allocation

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The basic meaning of asset allocation is to allocate an investor’s money across asset categories in order to achieve some objective. In reality, most investors’ portfolios would have the money allocated across various asset categories. However, in many such cases, the same may be done without any process or rationale behind it.

Asset Allocation is a process of allocating money across various asset categories in line with a stated objective. The underlined words are very important. First, it is a “process”, which always involves several steps, and those steps should not be ignored or skipped. Second, the whole idea behind asset allocation is to achieve some objective. Whichever approach one selects, one must go through the steps of the process in order to achieve the objective. There are two popular approaches to asset allocation.

Note: In order to keep the discussion simple, and to understand the concept of asset allocation well, we will use a two- asset portfolio, consisting equity and debt, as example in the discussion under this topic.

Strategic asset allocation

Strategic Asset Allocation is allocation aligned to the financial goals of the individual. It considers the returns required from the portfolio to achieve the goals, given the time horizon available for the corpus to be created and the risk profile of the individual.

In other words, it is an approach to maintain a target allocation across various asset categories. Such a target asset allocation across the asset categories is decided based on the analysis of the needs and risk appetite of the investor. Such an analysis would help a mutual fund distributor to arrive at allocation between various asset categories in percentage terms. This percentage target is also called the “strategic asset allocation”.

Tactical asset allocation

As opposed to the strategic asset allocation, one may choose to dynamically change the allocation between the asset categories. The purpose of such an approach may be to take advantage of the opportunities presented by various markets at different points in time, but the primary reason for doing so is to improve the risk-adjusted return of the portfolio. In other words, the attempt is to either reduce the portfolio risk without compromising the returns or to enhance portfolio returns without increasing the risk. Tactical asset allocation is also referred to as dynamic asset allocation. Tactical asset allocation is typically suitable for seasoned investors operating with a large investible surplus.

As an illustration, if the appropriate allocation to equity and debt in a portfolio is say 60:40 and equity valuations are attractive, it may be increased to say 65:35 or 70:30. If equity valuation is stretched, it may be reduced somewhat.

Rebalancing

An investor may select any of the asset allocation approaches, however, there may be a need to make modifications in the asset allocations.

Let us first start with the strategic allocation. In that case, the asset allocation is likely to change periodically, since the different assets may not move together in the same direction and may not move equally, even when the direction is the same. In such a case, it is quite possible that the current asset allocation may be different from the target allocation. What should one do in such a scenario?

Well, many practitioners advocate that the portfolio should be rebalanced to restore the target asset allocation. Their argument is that the asset allocation was decided by an analysis of the needs and risk appetite of the investor. We need to reduce the allocation to the risky asset if that has gone up. On the other hand, if the allocation has gone down in the asset that has the potential to generate higher returns, we need to correct that as well.

Such a rebalancing offers a huge benefit – it makes the investor buy low and sell high. Let us understand this through an example: Assume that the target asset allocation for an investor is 50:50 between asset categories A and B. A year later, asset category A went up by 20 percent, whereas asset B went down by 5 percent. In such a case, the allocation has deviated from the target. If we started investment of Rs. 1,000 each in both the cases, the value in both the cases would stand at Rs. 1,200 in asset A and Rs. 950 in asset B, with the total portfolio value at Rs. 2,150. The current allocation stands at 55.81 percent in asset A and 44.19 percent in asset B. This needs to be restored to 50:50. That means selling some part of the investment in asset A (worth Rs. 125) and buying some in asset B.

As we can see here the asset A, which has gone up, is sold; and asset B, which has gone down, is bought. This happens automatically, without the investor having to take a view on the direction of the markets.

The rebalancing approach can work very well over the years when the various asset categories go through many market cycles of ups and downs. On the other hand, one may also need to do a rebalancing of the asset allocation, when the investor’s situation changes and thus the needs or the risk appetite might have changed. Rebalancing is required in the case of strategic asset allocation as well as tactical asset allocation.

With the purpose to ensure uniformity across mutual funds, SEBI has provided the timelines for rebalancing of schemes. In the event of deviation from mandated asset allocation mentioned in the Scheme Information Document (SID) due to passive breaches (occurrence of instances not arising out of omission and commission of AMCs), mandated rebalancing period for all schemes other than Index Funds and Exchange Traded Funds is 30 business days. However, the mandated rebalancing period is not applicable to the Overnight Funds.

Disclaimer:        

The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. All complaints regarding Mutual Fund can be directed towards visit www.scores.gov.in (SEBI SCORES portal). Readers are requested to make informed investment decisions and consult Chaitanya Financial Consultants – 9000628943 / mfd.mmr@gmail.com to determine the financial implications with respect to investing in Mutual Funds.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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