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How Can Investors Prepare For Volatility?

Your IQ alone is not enough to prepare you for investing. EQ plays an equally important role. That’s the view from Kalpen Parekh, president of DSP Blackrock Investment Managers.

Markets fall every two or three years, Parekh said. “48 percent of the time they close lower, and 52 percent of the time they close higher. The odds are even,” he said on BloombergQuint’s Mutual Fund show. “But if one is investing smartly, the returns could go up to over 100 percent, as history has shown enough number of times.”

Markets’ mean revert from certain zone of valuations and returns. Yet, it’s difficult to time that. Investors have businesses, work and jobs, which demand more time and attention, he said. That’s why products like asset allocation funds and balanced funds are best suited for such investors. “Use products, depending on your appetite for fluctuations in your portfolio.”

Our wiring since the evolution of mankind is ‘fear or flight’. Our survival since evolution has happened because of this instinct. In investing, when there is fear, one thing that investors shouldn’t do is taking a flight out.
Kalpen Parekh, President, DSP Blackrock Investment Managers

Parekh, like most experts, agrees that for the long term, stick to equity funds and consider debt funds for short-term needs. Mutual fund schemes have different levels of asset allocation to debt and equity. There are also dynamic funds that calibrate exposure based on the cycles to reduce volatility in the portfolio and increase tax efficiency.

Still, investors shouldn’t choose funds based on the highest returns in the last one year, AUM Financial’s Nirav Panchmatia said. He recommends to buy funds in the asset allocation category and move money from small- and micro-cap category to large-cap funds.

Here are edited excerpts from the conversation.

How can investors prepare for market volatility?

Kalpen Parekh: Wise men say that it is not the IQ alone which determine how rich you will become, but it’s your EQ and temperament. So, wealth creation is all about time and discipline, and being able to ignore intermediate voices. Investment is a replica of nature. You have ups and downs, periods of good and bad returns. But as long as we recognize that, over long periods of time equity as an asset class only goes up. And that long period of time has to be 7-10 years.

There is data and evidence which highlights it. Investors should understand that every 2-3 years markets fall. It is the part of markets to go up and down. If you take daily returns, 48 percent times markets close lower, and 52 percent times they close higher. So, the odds are even, if you notice it on a short period like a day. As you expand your time horizons to a few years and decades, the odds of getting positive returns goes as high as 100 percent. If you invest in mutual funds, they cushion that volatility.

Over 7-10 years, large investors have made meaningfully higher returns than traditional investments asset classes.

Would you say that it is okay if we can’t predict volatility, but it is not okay to prepare for volatility?

Kalpen Parekh: For very long periods of time, the formula says that the markets mean revert from certain zone of valuations and certain zone of returns. So, when valuations are 10-12 times, then that is a great time to sell everything and invest in equity. When the markets hit a 30-times valuation, it becomes a bit challenging to earn future returns.

It is very difficult to try and time these things because we as an investor may not only be doing investing. We have other jobs which demand more time and attention because that’s where our core earnings come from.

Products like asset allocation funds and balanced funds give you an automatic hedge because they re-balance between equity and debt and they re-balance this around valuation points depending upon the interest rates and valuations.

One way to prepare for volatility is to acknowledge that there is volatility and not deny it. Use products depending on your appetite for fluctuations in your portfolio. There are many investors who say that if my money is for 10 years, I don’t worry what will happen for the next 2 years.

Most of us get unnerved and it is natural to do that. Our wiring since evolution of mankind is always fear or flight. So, when there is fear we flee. So, it is hard coded. By design our natural survival has happened because we react like this. But that instinct does not work in investing. In investing, our instincts have to be the opposite.

When there is fear, be bold and invest more.

Mutual funds have some very interesting asset allocation products. There are static asset allocation products which have a ratio of 65:35 in debt and equity. Then there are dynamic asset allocation products which change the ratio of debt and equity depending on which asset class is more attractive.

If fixed income yields are at 8.5 percent today, they are reasonably attractive than what they were one year back when bond yields were 6.5-7 percent. So, fixed income has become more attractive. Meanwhile, equity prices have gone up without earnings going up as much. While there is hope that earnings will recover over time, relative attraction of fixed income has improved. Any product which plays through these asset classes actively can be a preparation of volatility. So, investors need to look at this kind of products in their bouquet and plan accordingly.

What are these funds?

Kalpen Parekh: We have a fund called dynamic asset allocation fund, which looks at debt and equity every month, and gives more allocation to whichever asset class is more attractive. Currently, half the portfolio of that fund is in fixed income, and rest is in equity. So, it has calibrated its exposure as in recent times, the equity markets have been running up and bond prices are down because of the rise in interest rates.

At some time, if this equity volatility and correction continues, equity becomes more attractive. Then we will take money out of fixed income and put it in equities. This product over the next few years, if an investor were to look at and invest, is far more tax efficient. So, instead of the investors moving between these two asset classes, a vehicle like this can give tax-efficient lower volatility returns to an investor.

If somebody invests with a 10-year horizon in mind, advisors say that if you are investing for such a long period of time, then don’t bother with types of funds. What is your view?

Kalpen Parekh: The worst point to invest in the last 10 years was when the market was at its highest from a valuation point of view which was Jan. 2008 when the Sensex was around 21,000. From 21,000, it has gone to 26,000. That translates into a compounded annual growth rate of about 7 percent.

Fixed income in same period could have given you 7 percent. But, equities funds that delivered some amount of alpha, would have given you 10-12 percent CAGR. So, investors who ignored all the ups and downs in between and had the temperament to not look at it and act has earned higher than what fixed income would have given.

I am glad that from last few years, a lot of money has come through systematic investment plans. It means volatility is a friend of an investor because if markets fall you are buying more and more units.

If we want to buy anything in life, we want prices to fall, we celebrate corrections. In equity, we don’t celebrate corrections, but we worry.

SIP investors should expect that markets stay volatile, so you can accumulate in your accumulation phase. Indian investors have just begun their accumulation phase.  

In the same 10-year period where the market has given only 7 percent and funds have been giving around 10 percent returns, SIP could have delivered 13-14 percent CAGR because you benefit from this volatility.

So, investors doing SIP should worry least about volatility. They should be happy that their next unit will be at a cheaper price if the markets were to correct.
Kalpen Parekh, President, DSP Blackrock Investment Managers

Should investors use balanced funds to protect themselves from market falls?

Nirav Panchmatia: A balanced fund is a passive category. I would rather recommend a category known as asset allocation funds. Asset allocation funds as against balance funds have a range in which it can move equity allocation of funds.

Let’s take the example of ICICI Prudential Dynamic Plan. Theoretically, it can move money into equity in the range of 0 to 100 percent. Right now, that fund is 67 percent invested in equity. It can move all the way to 100 percent equity. A balance fund has maximum 10-15 percent gyration range available where it can move between or out of equity.

There’s no doubt that 2018 will be a volatile year. As U.S. bond rise, liquidity is being sucked out of the system. Same is happening in India, the markets are volatile. You need a fund where the fund manager can move more than 20-30 percent between equity allocation.

If the equity allocation in an asset allocation fund goes below 66 percent, does the tax treatment of the fund change?

Here is where the ingenuity of a mutual fund company comes into the picture. As per the requirement of the asset allocation fund, 65 percent of the money should be in equity, whether pure equity, naked equity or the investor can do hedging and go into futures and options. The investor can take arbitrage funds as well.

The fund manager will ensure that at no point of time, a combination of these three products will be less than 65 percent in equity, following which it will keep attracting equity taxation which is the lucrative part of this product. At the same time, even though you are enjoying equity taxation, you can move the needle down to having less that 50-55 percent money in equity if you feel that the market is very highly valued and risky. Likewise, when the market corrects, you can move 30-40 percent up into equity. That is what a layman investor is supposed to do, they tend to sell when others are selling, and tend to buy when others are buying.