Asset Allocation and Portfolio Rebalancing: Big Themes to Focus in a Volatile Market

Based on a discussion led by Jyotsna Singh, Business Head, Kotak Private Bank, at IMA India’s 25^th Annual CEO Roundtable, December 7-10 2023, Visakhapatnam

Senior managers such as CFOs are often unable to make the time to carefully review, let alone rebalance, their investment portfolios. Equally, with markets scaling new highs each day, it is easy to get carried away and make rash decisions that can prove costly in the long term. Following a few simple best practices can help avoid such mistakes and generate robust and relatively stable returns.

Recent trends in portfolio allocation

Historically in India, most investors have gravitated – either by default or by design – towards physical assets such as real estate and gold over financial assets. However, a marked shift is underway, with the share of physical assets dropping from 72% in 2014 to 65% this year. This is driven by factors such as rising awareness (including via social media) about the benefits of holding financial assets; digitalisation in the financial sector; better regulation and improved market efficiency; rising disposable income; and easier access to research tools.

Since Covid hit, there has been a reversal of trend, with money flowing back into residential property in particular. However, poor liquidity remains an issue and thus, there is growing demand for ‘smarter’ financial products across segments:

• Debt: Fixed-income instruments are believed to offer a low-risk/low-reward mix, but returns from such assets can vary from 6-6.5% for bank deposits to 16-20% for venture debt and real-estate funds. Recent innovations like equity savings schemes offer 7-8% returns with the added benefit of lower taxation.
• Equity: Investors face several questions when it comes to equity investing – whether to buy passive (including index) or active funds; growth or value stocks; whether to pursue a dividend growth strategy; or whether to engage in contrarian investing.
• Alternate assets: These have gained traction in India in recent years. The pros of investing in such assets include low correlation with other asset classes and potentially higher returns. The cons include poor liquidity, longer investment horizons, higher minimum investment amounts and (often) limited performance indicators.

Best practices in investing

It is generally true that equities deliver higher average returns but are more volatile than other assets; that fixed income offers stability; and that gold is a hedge against inflation. A mix of 30% equity and 70% debt would, in the last few years, have generated an average return of 8.7% with a volatility of 3.3% whereas an 80:20 mix would have generated 10.5% with a volatility of 5.2%. Yet, most people find it hard to stick to a chosen asset allocation strategy. Evidence shows that a disciplined approach to investing is the single biggest driver of longer-term risk and returns. It is the cornerstone of investing, and in fact, ~90% of all variations in returns originate here.

Regular portfolio rebalancing is vital, particularly in times of volatility, when different asset classes behave very differently. (Going forward, investors will need to brace for unexpected events – the ‘unknown unknowns’ – a few times a year, and geopolitics will continue to play an outsized role.) Data proves that strategic rebalancing can, in the long term, generate excess annualised returns of nearly 1 percentage point over a ‘no action’ strategy. This may seem like a small difference but given the power of compounding, it quickly adds up. A good general rule is to review the portfolio once a quarter and make rebalancing decisions while accounting for costs such as taxes and redemption fees.

With equity investments, returns rise and risks decrease with the time horizon. For instance, someone who has stayed put for the last 5 years would have earned a return of between (-) 1.5% and 47.2%, but stretching this horizon to 10 years would narrow the range to between 5.9% and 22.4%, with a near-zero likelihood of negative returns. Similarly, the difference in current portfolio value between someone adopting a buy-and-hold strategy since January 1, 2018 – thereby riding the wave of the ten best days for the market in this period – and someone who invests sporadically (and therefore misses out on those 10 days) is as high as 58%.

A few other rules of hand are important to keep in mind:

• Rather than taking an either/or approach to passive versus active investing, it is better to opt for an ‘and’ strategy. Index funds are a good option for large-cap investments but with small and mid-caps, active investing such as through fund managers who do bottom-up analysis, can pay off.
• Geographical diversification is vital: While the Indian markets have outperformed global markets in 6 of the last 10 years, they are also historically more volatile. India is also a small part of the global economy and the rupee has consistently depreciated against the dollar. Buying foreign assets provides access to unique businesses and reduces forex risk.
• Keep things simple – don’t seek complexity for complexity’s sake.