To buy or not to buy – Asset allocation holds the key…

With literally thousands of stocks, bonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor. However, starting to build a portfolio with which mutual fund or stock to buy might be the wrong approach. Instead, you should start by deciding what mix of assets in your portfolio you want to hold – this is referred to as your asset allocation. You should consider an asset allocation strategy based on your

• Time horizon: Asset allocation will depend on how long can you hold on to that particular asset and whether you need it for a particular goal. If you need any of your assets for let’s say a down payment for your house which is due next year, then probably holding debt/fixed income oriented instruments is an option you should consider. Examples of debt include Bank or Corporate Fixed Deposits, short term bond funds, short term bonds and ultra short term or liquid Funds. On the other hand if you have a long term goal like retirement, you can allocate a large portion to equity oriented instruments and lesser towards fixed income oriented instruments. As you move closer to the goal, you can keep reducing the equity portion while increasing the debt component.

• Risk tolerance: This is different for each one of us. An individual should have a realistic understanding of his or her ability and willingness to stomach large swings in the value of his or her investments. Risk tolerance will depend on age of an individual – middle aged individuals generally tend to be more risk tolerant, as they may have more capital available for investing and have longer term goals.

 

In a volatile market scenario like the one we are witnessing now, and have also witnessed in the past, asset allocation becomes all the more important. The table below shows Sensex High and low on various dates. It also shows percentage fall from high. As you can see , the 1 year returns are as high as 105.9% from April 2003, but are also accompanied by a negative 1 year return to the tune of -31% from January 2008 during the US subprime crisis. Thus, had someone invested all of their money in equity prior to 2008 without a proper asset allocation in place, he would have incurred high losses in 2008. If someone would have invested keeping their goals, time to goals, risk tolerance, savings and expense pattern in mind, they could have held on to their existing investments while strategically rebalancing their portfolio as against panic selling and booking losses. The situation that we are facing now in 2015 around the Greece bankruptcy crisis and Chinese slow down have also resulted in Indian markets correcting significantly. The fall might look attractive to a lot of investors, and they might start buying irrespective of the asset allocation they might have charted for themselves. In our opinion, such events will come and go, and it will always be a challenge for investors to know how much further they could fall. Therefore instead of trying to time the market or haphazardly investing in what looks attractive,e one should go by ones pre defined asset allocation, because what looks attractive today may lose its sheen tomorrow.

Table 1 : SENSEX fall history

Source: Bloomberg, Reliance Mutual Fund

Historically, broad asset classes move in relation to each other are fairly consistently (for eg., when stocks are up, bonds tend to be down and vice versa). In diversifying the allocation across asset classes, you can potentially create a portfolio with investments that do not all move in the same direction when the market changes. However, if you only spread investments only by industry (eg. automobiles vs. pharmaceuticals), they are all in the same asset class (i.e., all in equities) and respond similarly to market changes. You are therefore open to much greater market risk. Asset allocation helps keep volatility in check.

Ultimately, there is no one standardized solution for allocating your assets. Individual investors require individual solutions. Asset allocation is not a one-time event , it’s a life-long process of progression and fine-tuning. Empirical data shows that it pays to be diversified across asset classes.

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10 Step Guide to start investing

A very good graph showing 10 steps to start investing  by UTI Mutual Fund house.

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Your Umbrella For Life

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Are you saving enough for your child’s education?

The cost of education is increasing at a rate faster than normal inflation. Do you have enough for your child’s education? Are you aware of the best options for doing so? Do you have to sacrifice your other goals for achieving your child’s education? Read the article by Vishal and do comment how you are planning your child’s education.

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Don’t park all your Retirement Funds in FDs – A case study by Vishal Dhawan

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Market Mantra October 2014

India equity markets celebrated Diwali in style, with the Nifty regaining the 8,000 mark and the Sensex moving above 27000.

There was plenty of positive news flow from India like the Government announcing a series of policy reforms including diesel deregulation, gas price hikes and e-auction of the cancelled coal blocks. The victory of the BJP in the Assembly elections in Maharashtra and Haryana too buoyed sentiments.

Equity:

Nifty increased by 1.02% whereas CNX Midcap increased by 1.44% during the month.

The Price to Equity ratios continues to show that equity market valuations are above 20 Year average and it is therefore critical to see earnings pick up to justify current valuations . Early signs show that it is starting to happen as you can from the chart below on both PAT and EBITDA margins for Nifty companies:

Source: Motilal Oswal Research, 2014

In the graph below it is very clear that investment growth has picked up recently in India compared to some of the other emerging markets (like Brazil, Russia and Mexico), but needs to rise further for economic growth to improve structurally.

Source: Morgan Stanley Research, October 2014

Global economic growth woes continued – the IMF downgraded its economic outlook on the globe due to weaker than expected global activity in the first half of 2014, along with ongoing Middle East tensions, the Ukrainian and Russian standoff, along with the Hong kong political unrest. The new epidemic disease Ebola is also a big concern in U.S, African and European countries. News from Europe also continues to be challenging. The US ended its bond buying program but maintained its stances on keeping interest rates low for a considerable period, in line with market expectations. Whilst it is very tempting to move to a 100% domestic portfolio in this environment, we continue to recommend to have at least 10% of the portfolio invested globally for the purpose of global diversification, as well as act as a hedge against currency risk.

With projections of GDP growth of 5.5 percent in FY 2014–15 and 6.5 percent in the following year, Q2 2014 GDP growth came at 5.7%, above the consensus expectations. We believe that the Indian economy is on the cusp of a growth uptrend and this will contribute to growth in corporate earnings as we have shown in our charts above in this article and hence will justify strong performance of Indian equities, especially with oil and commodity prices coming off. However, it is critical to keep you asset allocation intact.

Source: MSCI, Credit Suisse, I/B/E/S, FactSet, J.P. Morgan Economics, J.P. Morgan Asset Management “Guide to the Markets – Asia.”

Fixed Income

CPI inflation eased to a series-low 6.5% in September 2014 from  7.8% in August 2014 in year-on-year (y-o-y) terms and Core-CPI inflation (excluding food, beverages & tobacco and fuel & light) declined significantly to a series-low of 5.9% in September 2014 from 6.9% in August 2014 (refer chart below)

Source: CSO, ICRA Research

Inflation related to fuel & light moderated to 3.5% in September 2014 from 4.2% in August 2014 in y-o-y terms. Softening of prices of various commodities including crude oil and domestic fuel prices would benefit the CPI trajectory in the near term and hence we continue to expect the Reserve Bank of India’s (RBI) January 2015 target of restricting CPI inflation below 8.0% to be achieved.

Nevertheless, the probability of a Repo rate cut in 2014-15 remains low, as the RBI is likely to continue to focus on containing inflationary expectations to improve the likelihood of restricting CPI inflation below the January 2016 target of 6.0%.

The below chart shows the Interest rate differentials between US and India:

Source: Axis Mutual Fund

There is a fear that higher US rates will draw FII money away from India. This is not borne out by history. During 2004-06 even with rate hikes money continued to flow into India from FIIs. Secondly, back in 2004 at the start of the cycle, US rates were at 1% and Indian rates were at 4.5% implying a 350 bps differential. By the end of the Fed rate hikes, the rates were respectively 5.25% and 6.50% implying a differential of just 125 bps. In contrast currently the US is close to zero (officially the overnight target is 0 to 0.25%), while RBI is at 8%, a differential of nearly 800 bps.

Hence, we recommend having the fixed income portion of the portfolio comprising of both accrual and duration strategies where accrual strategies will lock into current high interest rates and duration strategies will start benefitting once the interest rates start coming off over the next 12-24 months.

Gold:

Demand for Gold has seen a rebound in recent days in India and China. India celebrated Diwali, the biggest gold buying festival  which boosted physical demand for the yellow metal on support of low prices. Meanwhile, a surge in Gold imports pushed up the India’s trade deficit for September to $14.25 billion of which Gold imports accounts for $3.75 billion. This raises questions on whether there can be some quantitative restrictions or higher import duties put on gold , to bring down the demand. Hence, allocating only a smaller portion of your portfolio in Gold continues to be a prudent strategy.

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History- Don’t forget the learnings from the past.

 

RBI has , last night, once again introduced measures to tighten liquidity, so that the fall of the rupee can be controlled by removing liquidity for possible speculation on the rupee. Whilst this may seem like a localized response to many and unique to India, it is important to note that similar measures have been announced in Turkey, Brazil, Indonesia and China in different forms. Bond markets in India have reacted sharply to these tightening measures and are likely to do so every time these measures are announced. However, it is important to look at this from a historical perspective as the widely held view is that these measures are temporary in nature. If one looks at past measures of currency defence by the RBI, and the resultant measures and periods that it takes to reverse such measures, it provides some interesting insights. Four periods have been considered here:

1. 2011-12, when the rupee depreciated after the emergence of the Euro crisis and the US debt downgrade.

2. 2008, during the period of high oil prices and the global financial crisis.

3. 2000, post the tech bubble bursting

4. 1998, in the aftermath of the Asian financial crisis

PERIOD	DATE OF MEASURE	RBI’s ACTION	BOND YIELD IMPACT	REVERSAL DATE	PERIOD RUN
1998: Asian Financial Crisis	Jan 1998	· Increase in bank rate by 200 bps· Increase in CRR by 50 bps	· Immediate increase in yields· But within 1 month yields decreased though it took a few months to fully normalize	Mar 1998	· Policy: Approx. 2-3 months· Bond Market: 1 month
2000: Tech Bubble	July-Aug 2000	· Increase in bank rate by 100 bps· Increase in CRR by 50 bps, 25 bps immediately reversed	· Immediate rise in yields· Yields peaked by Nov 2000 · But reached a new low within 6 months	Feb-Mar 2001	· Policy: Approx. 6 months· Bond Market: 2-3 months
2008: Global Financial Crisis	Jun-July 2008	· Increase in repo rate by 125 bps· Increase in CRR by 75 bps	· Immediate rise in yields, however rates peaked before the last rate hike· Yields set a new low within 2 months of rate hike	Oct 2008	· Policy & Bond Market:Approx. 1-2 months
2011-12: Aftermath of the US Debt downgrade	Sep-Dec 2011	· Increase in FCNR & NRE rates· Increase in repo rate by 100 bps	· Yields peaked in Nov 2011bu reversed all losses by end Dec 2011· But reversed all losses by end of Dec 2011	· CRR cut in Jan 2012· Repo rate cut in April 2012	· Policy : Approx. 6 months· Bond Market: 2-3 months

Source: Bloomber,RBI, Axis Mutual Fund

As you will see from the data above, whilst bond markets sold off in response to RBI measures, bond yields typically peaked very soon after the policy actions and resumed the downward trend soon after. The total period of the bond market stress was 1-3 months, whilst RBI itself reversed the measures within 2-6 months. Thus, all these measures were temporary and were reversed when it became apparent that the impact on the domestic economy was worse than the marginal impact on the exchange rate.

Therefore, from an investor perspective, it is important to view your holdings in bonds and bond funds keeping this perspective in mind ie if you have a short term holding period, you need to be concerned about the volatility, but if you have a long term horizon, and are using bonds and bond funds as a part of your overall asset allocation strategy, you should look at these opportunities to buy into this volatility over the next few months.

Of course we should not forget what Warren Buffet once remarked “If past history was all there was to the game, the richest people would be librarians.”

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“I told you so. Why weren’t you listening? ” RBI to bond markets

As the Indian Rupee continued to face downward pressure against the US dollar, the Reserve Bank of India, late on Monday, took the classical textbook response to a falling currency by indirectly raising interest rates, following in the footsteps of other emerging markets, including Brazil and Indonesia.

The bond markets were surprised and saw a big sell off on Tuesday as a result. But should they really have been? RBI, over multiple conversations for many months now, has been talking to bond market participants and explaining that whilst falling inflation is good news and gives them some leverage to bring down interest rates to boost slowing growth, there is also a significant focus that they have on the external environment considering the high current account deficits that India runs and the possible tapering of Quantitative Easing by the Fed, which needs to be kept in mind as well. Unfortunately, most bond market participants were not listening, or listening to only what they wanted and liked to listen to.

Essentially, the RBI has been trying multiple things to stabilize the depreciating rupee with limited success thus far. A falling rupee is not good news for India due to the inflation risks that it poses, and high current account deficit as well as India’s dependency on foreign capital flows. Thus, as a part of its rupee management process, the RBI brought in three steps to reduce liquidity, and thereby speculative activity on the rupee:

1. Increased interest rates on Marginal Standing Facility ( MSF) by 2% to 10.25% – This is the penalty rate at which banks can borrow over repo rate.
2. Announced sale of Rs 12000 crores of G Secs under Open Market Operations (OMO) – ie it will sell securities to market and mop up liquidity
3. Capped liquidity under Liquidity Adjustment Factor ( LAF) at 1% of Net Demand and Time Liabilities ( NTDL). This means bank borrowings above Rs 75000 crores will be at 10.25%.

The good news is that these steps have brought in, through a manner that they can be changed overnight, just like they were introduced, unlike a classical interest rate hike that can take much longer to reverse. Thus, RBI could pull these steps back very easily, if the rupee stabilizes.

Whilst the bond markets adjust to this, there is likely to be a negative impact on a mark to market basis that investors will see on their bond portfolios, whether held through short term bonds or long term bonds or even liquid/liquid plus funds.

We believe that as bond markets digest this news over the next few days and weeks, there is an opportunity for long term investors to buy into this weakness from a medium to long term perspective. Short term bond funds, fixed maturity plans and dynamic bond funds are good options for investors to look at in this environment, considering their tax efficiency if held over one year.

The next time your spouse nags you about something continuously, please listen. You don’t want her to tell you – I told you so!

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