By Himadri Chatterjee, Senior Managing Partner, IIFL Wealth
One of the foundations of successful wealth management is diversification through asset allocation. Mathematically speaking, a portfolio of low-correlated asset classes (and within asset classes, low-correlated securities) can deliver market-like returns with relatively low portfolio volatility.
A cognitive bias associated with investments merits mention here: loss aversion. Investors experience significant psychological trauma thinking of a loss compared to the pleasure of an equal gain. They, therefore, find value in asset class diversification, which has been shown to limit downside volatility.
The question before us is how to maneuver between domestic and global diversification. A simplistic answer “do both, of course!” is intuitively appealing and when implemented wisely, may meet the needs of most investors.
In India, investors can easily diversify between traditional asset classes of equity, fixed income and gold. Mutual funds provide a convenient platform to construct diversified equity and fixed income portfolios, offer low investment thresholds and typically high liquidity. Investors may need to expend somewhat greater effort to research newer asset classes such as InvITs, REITs and unlisted investments. Investors may consider the following essentials to diversify domestically:
Long-term risk-return characteristics: Fixed income typically delivers stable returns than equities or gold. Equities may offer significant capital growth but also suffer from sharp drawdowns (fall from peak values). Gold may witness long periods of moderate growth followed by equally long periods of flat growth or decline. REITs and InvITs may provide regular income but may suffer capital erosion owing to interest rate movements. Unlisted investments may offer the highest return though the failure rate may be high, and the illiquidity may not suit all investors. The proportion deployed between various asset classes is perhaps the most important decision to make.
Relative drawdowns: All asset classes suffer losses from time to time. How they do so relative to each other is an important consideration. If gold and fixed income do not fall when equities are looking weak, it makes a strong case for diversifying into them. Similarly, unlisted investments may not change strictly in line with macro policies or interest rate movements, both of which impact the traditional asset classes significantly.
Inter-asset class diversification: Investors should diversify between sectors, business cycles (some industries may boom while others decline), large and mid-sized players. Financial innovation such as ETFs for equity, fixed income and gold have made it relatively easier to create a diversified portfolio within each asset class as well.
The proof of the pudding: Portfolios with meaningful diversification across asset classes (and within each asset class) have protected investors from severe drawdowns while substantially capturing the upside.
Global Diversification Toolkit
We can view global investing as diversification across countries and currencies, business cycles, earnings cycles, sectors and tax regimes. Here are some points to consider:
Macroeconomic cycles: Despite the interconnected world we live in, countries are often in different stages of the economic cycle (boom, recession, depression, recovery). Wisely allocating across global macro cycles can potentially orient a portfolio with global growth.
Earnings cycles: A similar strategy is possible within a sector. For example, the earnings drivers for US tech are different from those for Indian tech companies. An investor allocating across both can reap from diversification of the two earnings cycles.
Valuation cycles: Often, countries are also in different stages of their current valuation vs historical valuation. Global diversification allows investors to diversify across valuation cycles too.
Sector diversification: An Indian investor may find fewer domestic opportunities in sectors such as consumer-tech, Artificial Intelligence Markup Language (AIML) and semiconductors, among others. In such cases, a global portfolio provides access and diversification at the same time.
Availability: Indian investors may use feeder funds to invest in global funds/indices without limit or may utilize LRS limits to invest in global funds, stocks, bonds or managed accounts. Over the last few years, both these options have increased substantially.
Low correlation: Major global indices (S&P500, Nasdaq, China and Europe) have low correlation with Nifty500 ranging from 0.49 to 0.63.
Things to watch out for:
Limited knowledge and time: A typical Indian investor may not be well-versed with global markets. Dipping in their toes and allocating systematically may work better than one-shot investing.
Allocation guide: One can allocate between countries based on their contribution to incremental world GDP, e.g. US GDP $21 tn and growing at 2 per cent p.a., China GDP $14 tn and growing 6 per cent p.a. Accordingly, the US and China may be the biggest beneficiaries of an investor’s global funds.
Do the results stack up?
Our research suggests that a 10, 15 or 20-yr portfolio comprising 80 per cent India equity and 20 per cent developed-market equity has provided returns that range from 94 per cent to 108 per cent of India returns while the volatility has ranged from 88-89 per cent of India markets. This is diversification at work: near-market returns with lower volatility.
To sum it up…
Diversifying within domestic asset classes is a must for investors. Global Diversification can be an additional tool, to be used wisely. A combination of both strategies can broad-base the return profile and reduce volatility without sacrificing returns.