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Monday, Dec 15, 2003

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The importance of tactical asset allocation

B. Venkatesh

IN RECENT times, many fund houses have filed offer documents with the Securities and Exchange Board of India to launch Monthly Income Plans (MIPs). Such funds invest a substantial proportion of their portfolio in bonds, and take small exposure in equity to enhance portfolio returns. But if bond and stock markets were to become more volatile, there may be a greater need for funds that invest in equity and/or bonds depending on the relative performance of both markets. Such funds will emphasise on tactical asset allocation (TAA) strategy.

Asset allocation: This refers to the strategy of allocating money between stocks and bonds. Typically, balanced funds invest up to a maximum of 65 per cent in stocks and keep the balance in bonds. A TAA fund, on the other hand, could invest fully in stocks if the relative performance of this market were better. If the portfolio manager is of the opinion that equity values will tank, the fund at the extreme will be fully invested in bonds.

The mutual fund industry has not felt the need for such a fund at present. The reason is that stock market has trended upwards in recent times. In such a market, equity returns tend to be substantially higher than that from bonds. The one-year average return of diversified equity funds is 50 per cent compared with 10 per cent for gilt funds. When differential returns are so high, risk-seeking investors would prefer diversified equity funds, while the risk-averse ones would continue with bond funds. Those with moderate risk appetite may prefer MIPs. That is, perhaps, why we find more MIPs, pure equity and bond funds in the market.

Need for TAA funds: A tactical asset allocation strategy will enhance returns when asset prices are volatile. Now, asset price volatility comes in clusters. That is, asset prices exhibit low volatility for considerable period followed by high volatility for considerable period. The change in volatility from low to high may be random.

Typically, the asset price volatility is low when markets trend in one direction. That is why the initial phase of the current stock market rally saw prices move up on low volatility. When investors take profits at higher levels and the equity values reverse direction, volatility typically increases. That is when the TAA fund will assume importance. The portfolio manager, if she considers the stock market risky, may overweight bonds to increase the risk-adjusted return. A TAA fund may be, thus, able to generate good returns at lower risk compared to pure equity fund, or may provide higher returns with similar portfolio risk. Of course, portfolio mangers will able to replicate the TAA strategy with fund of funds (FoF). Such funds will shift exposure between bond and equity funds depending on the market condition. But the problem with fund of funds is that the asset allocation process is active while the stock selection process is not.

A portfolio manager of an FoF may actively allocate assets between, say, Franklin India Prima Fund and K Gilt Investment Plan. The portfolio manager of Franklin India Prima Fund is responsible for that fund's stock selection. The portfolio manager of an FoF is, therefore, passive so far as stock selection of Prima Fund is concerned. This imposes the investors of FoF to the consistent style bias of the funds in which the FoF invests.

A TAA fund can overcome such a consistent style bias. The portfolio manager of a TAA fund may initially choose to invest in large-cap stocks, but later switch to mid-cap tech stocks. In essence, the fund may not follow a consistent style bias, but may move into sectors perceived to provide better value. Such a fund can add value if the portfolio manager is skilful in asset allocation and stock selection. Of course, such funds will carry high management fees to compensate for the high skill required of the portfolio manager.

At present, there are three funds that follow an asset allocation strategy — the FT India PE Ratio Fund, Prudential ICICI Dynamic Plan and UTI Variable Investment Plan. The PE ratio Fund and UTI's Plan, however, use index levels as proxy for asset allocation. The Prudential ICICI Dynamic Plan allows itself much leeway by not confining to such a strategy. Investors may need more funds that follow active asset allocation and stock selection process, as the markets turn volatile.

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