The reason being as globalization progressed the economies had become intricate, increasing the correlation between equity markets across the world.
A heterogenous portfolio can be created by diversifying capital across asset classes to maximize returns subject to risk and cash flow constraints of an investor.
Exhibit 1: Calendar Year Performance across Asset class & Sub-Asset Class
Exhibit 2: Table of Index & Vanilla Hybrid Fund
Exhibit 2A &2B: Index & Hybrid Fund Return & Volatility
Investors can derive from Exhibit 1, that no asset class consistently outperforms the other in the short term and the 10-year CAGR construes investing over a longer horizon will compound wealth.
Exhibit 2 explains that even a vanilla hybrid fund can maximize returns and mitigate volatility for the risk taken. The grounds for that being asset classes, barring a few exceptions, tend to be influenced inconsistently by macroeconomic occurrences yielding better risk-return trade-offs.
The appropriate proportion of capital to be allocated to assets is crucial in building an optimal portfolio. If not, investors are exposed to unwarranted risk. For example, if an investor were to invest 100 percent of the capital in the index as shown above, she will be exposed to undue volatility.
However, tactical asset allocation will integrate capital market expectations with investor’s desired level of risk, and constraints focusing on the long term as exposures are targeted based on quantifiable systemic risk of each asset class thereby generating maximum returns for the risk investor can hold out against.
The accelerated pace of change in the markets and the evolving terrain for sectors may incline investors to time the markets and take exposure to the sectors in trend. However, market timing remains an evasive concept for most and to gain a differential advantage is much more difficult than one is inclined to believe.
The Buffett & Yardeni models can act as indicators of when prices move beyond reasonable ranges of valuations.
The Buffet Indicator Model
The aggregate market cap of publicly traded stocks in a country divided by the country’s gross domestic product or GDP is a broad way of indicating the domestic equity market’s relative position.
In general, if the indicator is above the long term average then equities are overvalued and vice versa.
The Yardeni Model
A derivative of the commonly known Fed model is used to gauge the positioning of the markets relative to valuation.
The Fed Model points towards overvaluation if the earnings yield of an equity index is underneath the yield of 10-year G-secs. The Yardeni Model improves on the blemishes of the Fed Model by incorporating expected earnings growth rate. If the indicator is above the long-term average, it points towards the equity market’s overvaluation and vice versa.
EY = BY – (k*LTEG)
EY: Earnings Yield
BY: Moody’s “A” rated corporate bond yield
LTEG: Long term earnings growth of the index
K: Constant assigned to earnings growth
We believe that more than 90 percent of the variance in returns can be delineated by asset allocation. An essential part in times such as this is to be disciplined and endure as the asset allocation underpinning the investment philosophy will prove to be effective as it has stood the test of time.
(The author is Founder and fund manager – Right Horizons PMS)
(Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of Economic Times)