What are the 3 Ts of asset allocation & portfolio strategies to follow? Arun Kumar explains (2024)

Arun Kumar, Head of Research, FundsIndia, says as an investor, you have to say what is your timeframe, what are the near-term declines that you can tolerate and that declines the more debt you add. There is also a trade-off in terms of my long-term returns. Now, based on all these three Ts, one can come to an asset allocation.

For most of our investors, FundsIndia either goes by 70% equity, 30% debt, or 50% equity, 50% debt or 30% equity, 70% debt. Again, different investors will have different combinations based on how they look at these three Ts. That is how to come to an asset allocation starting point.

What exactly is the concept of asset allocation?
In very simple terms, asset allocation is essentially that if you have to invest Rs 100, you take a call saying how much of that Rs 100 goes into equity, how much into debt. Broadly these are the two starting points and obviously one can add other asset classes like say gold or real estate and obviously cash is used as an asset class globally.

For all practical purposes, these four are more or less more than enough for you to build an asset allocation model. Overall the idea is how do you split your Rs 100 into these four different asset classes? Now on the mutual fund side, broadly it is equity, debt and gold. Coming to real estate, we all have some allocation towards it. Now whether you consider it as a part of your financial portfolio or not is a different question but broadly, in simple terms, equity, debt and gold is a good starting point.

How do you determine the appropriate asset allocation for a client because that is a very important exercise that one needs to follow?
Let us keep it really simple and look at only two asset classes like equity and debt. Obviously you can extrapolate this framework to accommodate other asset classes, but just for our understanding, the way we try to build an asset allocation portfolio is we call it the 3T framework. The first T is time. Ideally one has two different asset classes which is equity, which at least historically has done well over the long run compared to fixed income or debt. Again the caveat or the catch is that in the shorter run, inevitably one will always have a temporary decline happening, almost every year.

If you look at Indian markets, there is a 10-20% kind of a decline. It is almost a given that once every seven, ten years, one should be mentally prepared for a 30- 60% fall. This has happened in the last 40 years. Now the unfortunate part is that we do not know when that 10% to 20% fall going to get converted into a 30-60% fall. This is the balance of equity of this asset class.

Now a lot of us cannot handle it, so we want to curtail this temporary decline. So, we add a debt asset which is far more stable. But again the trade-off here is that over long periods of time, the returns from debt is more or less at the rate of inflation plus 5-7% and good fund managers are able to do a far better job over and above this.

But broadly, this is the way you look at it. So, the longer the timeframe one has, the more can one accommodate more exposure to equity. So, the first leg would be to look at the timeframe. Anything longer than five years can accommodate equity. The longer the timeframe, the more you can accommodate equity.

The second T is the tolerance to declines. As I told you, pure equity is down 10-20% almost every year and then 30% to 60% once every seven, ten years. So, net-net, this is not something a lot of us can tolerate. So, we add more debt. Let us say you put 30% of debt and 70% of equity. The same tolerance band probably comes to 15% of a temporary fall every year and then the longer, once in a seven-ten-year kind of a major fall is reduced to 35% vis-a-vis the 50% for pure equity. Then again, if one puts 50-50, one will again reduce it to say 10% regular falls and say a 25% once in seven-ten-year fall. So, this is a trade-off one makes. The more you add debt, the shorter is that temporary fall, number two.

The third T is the trade-off. Nowthen obviously if you show only the second part, then people will say, hey, I put almost a lot of money in debt and then reduce my temporary declines, but the caveat is that there is a trade-off on the longer run. Somebody at 12% returns is probably doing 10X in 20 years mathematically. And if you are doing a 10%, then it is almost 7X in 20 years and then at 8%, you are at 5X in 20 years.

So, the more debt you have, the more your returns are also coming down. There is a trade-off in the longer term. So, as an investor, you have to say what is your timeframe, what are the near-term declines that you can tolerate and that declines the more debt you add. There is also a trade-off in terms of my long-term returns. Now, based on all these three Ts, one can come to an asset allocation.

For most of our investors, we either go by 70 equity, 30 debt, or 50 equity, 50 debt or 30 equity, 70 debt. Again, different investors will have different combinations based on how they look at these three Ts. So that is how we come up with a broad asset allocation starting point.

What type of subcategories are we talking about? What will a very well diversified portfolio typically include?
When you start with equities, the usual approach would be to look at some exposure to largecaps, midcaps, and then smallcaps. Now, how do you decide on this? Broadly, look at the overall market structure, put the top 500 stocks and then say what is the weightage for each of these largecaps which is the top 100 stocks? The next 150 stocks are midcaps and the remaining stocks are smallcaps.

Broadly, at least from an Indian context, one would roughly have 70-80% in largecaps and then probably 10-15% in midcaps and 5-10% in smallcaps. This is the rough metric that somebody can look at for building a very simple portfolio. The way we do it is slightly different because we have seen that within largecaps, different funds follow different investment approaches. So, when you club everything as largecaps, we find that within the same category, we have very different approaches being clubbed together.

So, we follow something called a five-finger strategy. Essentially we are saying, hey, can we figure out five different investment approaches which have proven to work not just in India but across the world and over a long period of time? This is also fancily called Factor Investing where essentially we have identified the investment styles. Some fund manager are more biased towards the value or the contrarian kind of an orientation and that is one approach.

The second would be growth at reasonable prices, kind of an approach.

The third would be quality but at a slightly expensive valuation kind of an approach.

The fourth would be midcaps and smallcaps which is basically saying that the smaller sized companies will have a slight edge over the long run.

The last would be the global basket.

So, overall, you combine value, growth at reasonable price, quality, mid and smallcap and global at 20% each. We have been running this for almost the last three-four years. We have seen that each and every year, there are two or three styles which do well and then the other two styles do not do well, but it is very difficult to figure out which is that exact style which will do well. The problem with the whole idea of asset allocation is that we do not have a precise idea on which asset will do well at what point in time.

We apply the same logic here saying that even within the asset class, we do not know exactly which style will do well at what point in time; but if we club together all these styles which have proven to work well over seven to ten year cycles, then that intermittent phase where two or three funds are not doing well because of the style going through the underperformance, we are able to handle it better because at a portfolio level the client still has a smoother experience.

So, overall, this is how we do it and within that, we look at flexicap funds or funds where the fund manager is not constrained by having to compulsorily invest so much into largecaps, so much into midcaps. Except for the mid and smallcap bucket, in all the other four buckets, we predominantly go for funds where there is not much of a constraint on the fund manager and if a contrarian fund manager finds an opportunity in whichever segment, he or she is free to take it. So that is how we do it on the equity side.

On the debt side, it is fairly simple. There are only two risks to look at; interest rate risk and credit risk. We go for super high credit quality funds where at least 80% or more are into AAA oriented papers and then on the interest rate side, we say duration of not more than three years. This becomes our base bucket.

If you need some extra kicker on that, say up to 20% to 30% of your fixed income portion, you can put it into some categories like equity savings where you have some equity component. We do not do credit risk funds, but there are also slightly longer duration funds to get that extra kicker. But this is completely optional.

Most beginners should keep it really simple to a short term or a low duration. Most of the banking and PSU or corporate bonds have super high credit quality and the interest rate risk is limited to less than three-year duration. That should be good enough. So, this is how we club the diversification part within equity and within debt.

How can one place strategies in an active or passive way and how can one monitor and adjust asset allocation over time? Do you need to adjust a client's asset allocation regularly in response to the changing market conditions?
Yes. The easiest question is how do we monitor asset allocation over a period? We have six-month reviews where the broad idea is how far are you deviating from the original asset allocation that you have decided. Now, some bit of deviation is fine because if you keep your band too tight – let us say you are at 70% equity, 30% debt, we are okay for a plus or minus 5% kind of a deviation.

Let us say your portfolio is at 73% equity, we would not necessarily move 3% back because net-net, those small deviations are fine. Let us say it goes to more than 5% and comes to 76% or say 64%, then we might want to rebalance. But broadly in terms of frequency, there has been a lot of study done globally and we have also done a lot of work around it. There has not been much of a difference, even if you do it three months or six months or one year.

Most of the studies across the world have seen that there is hardly any significant differential and there is no pattern to it. So, while we do a six-month review, ideally we want to do those rebalancing activities once a year, unless and until there is a very sharp move within the year.

Usually, if you are doing it in January, there might be years like 2020 where you had a sharp fall of 40%. In those cases, we will want to step in and do some bit of rebalancing. But otherwise, 90% of the times, it runs on a one-year schedule and in a lot of years, you might even see that it is still within the band. So it is not like every year you will be forced to do it.

This keeps your activity at a lower level so that you are leaving the portfolio untouched for some point in time. Only in rare cases where it is required, you come and rebalance. It is only in a few years that moves are very dramatic and then also it is always on the equity side. That is where you will need to step in between the year and then do some rebalancing activities. That is how we look at the asset allocation rebalancing part.

In terms of active versus passive, right now, we are still heavy on active. When we say passive, we forget what is the underlying thing. Essentially you are saying that hey a larger sized company will do better than a smaller size company. Net-net you are saying this is a rule which says the larger the size the better it is for my returns.

Large-sized companies have done well for the last 10 years, especially in the US and also in India, we have seen that in the last five years. Usually passive tends to do well, but for us, it is yet another style. The way we look at it is larger the better is one style, smaller the better is one more style and the higher the quality, the better is one more style which you call quality. Lower valuation the better is the valuation style. The higher growth the better is one more style.

We are not biased towards one particular rule but this being said, we think at least in the largecap segment, passive makes a lot more sense because a lot of funds have a very high overlap with the index and given that the expense ratios are also on the higher side, just to compensate for that differential, one will need a significant outperformance on the remaining portion.

Only 40% of the portfolios of largecap funds were different from the index and that is also because we have a constrained universe and there are a lot of stocks which a lot of fund managers do not go for. So, it is a narrow index and the overlap is inevitable.It is very hard for a largecap fund manager to outperform on a consistent basis. So, in that segment, we are a little more biased towards passive.

But most of the other segments, at least the flexicap and all these different styles which I was speaking about, we play it through active. So, it is a combination of both based on the client's preference. Passive is purely largecap but if a client wants an active portion, we club together these five styles and let it run. So, we have both the styles.