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Suresh Krishnamurthy

FOR investors in mutual funds, a simple strategy of opting for two or three eq8

uity funds may be appropriate and hold the scope for reducing risks. Taking this approach further by adopting rebalancing strategies may however not pay. Transaction costs, taxes and the lack of depth in the markets render rebalancing ineffective. Performance numbers over the last five years support this view.

If you invested 50 per cent of your money in one fund and the rest in another in the beginning, the proportion would have changed at the end of a year because of divergent performance. To remain properly diversified, you can restore the original proportion by rebalancing. However, this act of rebalancing has not added value.

Annual rebalancing of two fund portfolios and three fund portfolios does not reduce the risk of below-average performance. In addition, the returns, even before adjusting for costs and taxes, are not materially different. In other words, if adjusted for costs and taxes, such a strategy will provide lower returns than buying two or three funds and holding on to them.

The effects of a less frequent than annual rebalancing were not observed. However, intuitively, they make even less sense than annual rebalancing. The effect of a 30 per cent short-term capital gains tax (as opposed to a 10 per cent long-term tax for annual rebalancing) can cripple a strategy of monthly or quarterly rebalancing. In addition, costs of implementing such a strategy (entry loads, for instance) can be significant.

Case for diversification

A mutual fund is a portfolio of stocks. It is supposed to provide an investor with the complete benefits of diversification. However, if you are worried about your choice of mutual fund and the risk that it will perform below average, a diversified portfolio does make sense.

Mathematically, holding more than one fund should reduce risks. More than two funds should reduce the risk further.Overall, a portfolio approach would reduce the risk of holding on to the wrong fund — one that consistently performs below par.

Numbers support this view. Since the divergence in performance has been significant in the past, the benefits from diversification have also been material.

In a select list of ten funds, a two-fund portfolio reduced the risk of below average performance by 36 per cent compared to a single-fund portfolio. A three-fund portfolio similarly reduced the risk by around 52 per cent compared to a single portfolio.

In terms of numbers, the worst performance is 34 per cent returns for a single-fund portfolio. Returns refer to the appreciation for the period between September 1998 and October 2002.

For a two-fund portfolio, the worst performance is 38 per cent. For a three-fund portfolio it is 47 per cent. While mathematically, the returns should naturally trend higher in the case of a combination of funds, the extent of rise is significant and due to the wide divergence in performance.

Rebalancing effects

The benefits indicated earlier refer to a buy-and-hold approach. What happens if you rebalance the portfolio on an annual basis?

In the case of two-fund portfolios, rebalancing improved portfolio performance in 34 out of 45 combinations. However, the improvement did not appear sufficient to compensate for the incidence of taxes and costs. In the rebalancing of three-fund portfolios, the results were even more disappointing.

Importantly, it did not reduce the risk of under-performance. Rebalancing would have made sense had it lowered the risk of under-performance, even if it did not lead to any improvement in average returns. But, unfortunately, that did not happen.

Lack of depth

Studies in the US, where there is more choice, suggest that holding rebalanced multi-fund portfolios reduces the risk of under-performance considerably. The lack of benefits from rebalancing, on the contrary, may be because of the lack of depth in the Indian mutual fund market.

In fact, studies indicate that movements in such indices as the BSE 200 or S&P CNX 500 explain a substantial proportion of changes in the net asset value of almost all the prominent funds. For example, 75-85 per cent of changes in the NAV are explained by changes in the broader indices. Thus, it is hardly surprising that rebalancing has not enhanced the benefits from diversification.

Loss of upside

There is another side to diversification too. While it reduces the risk of under-performance, there is also a trade-off in a possible loss of upside.

For example, had you zeroed in on Alliance Capital Tax Relief in September 1998, you would have been better off had you not diversified. Or, had you zeroed in on Prima, now part of the Franklin Templeton stable, in September 2001, it again made sense not to diversify. Had you diversified, your returns would be lower.

In other words, diversification works both ways — it reduces the risk of under-performance. At the same time, you will have to forego a bit of the upside. For example, the best-performing single-fund portfolio generated absolute returns of 220 per cent while the best-performing two-fund and three-fund portfolios generated returns of 178 per cent and 168 per cent respectively.

This is only to be expected. In addition, since diversification is sought only by the risk averse, the loss of upside should not enter the calculation at all.

How many?

Now that the benefits of diversification are established, how many funds will make a diversified portfolio? The performance of the two-fund and three-fund portfolios indicates that the benefits from the inclusion of a third fund are still considerable.

The risk of under-performance is reduced by a further 25 per cent by including the third fund. Still, the answer to this question depends on how risk-averse the investor is.

A particularly risk-averse person may settle for a three-fund portfolio. A less risk-averse and more return-seeking investor would opt for a two-fund combination.

There may be a mathematical justification for considering a four-fund portfolio too. However, more than three does not sound appealing.

You may only end up adding a low return fund to your portfolio and forego potential upside. In other words, a three-fund portfolio appears an attractive proposition.

A few caveats

Only the effects of equal-proportion balancing were observed. The effects of unequal proportion balancing may have been substantially different. It may even have reversed the outcome.

The period under consideration is relatively — just four years. Trends may change when reckoned from a longer-term perspective. While the diversification benefits will still accrue over the longer term, diversification with rebalancing may provide better results.

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