Discussions on asset allocation have so far largely focused on diversification amongst assets i.e. equities, balanced funds, fixed income, non-financial assets and to a lesser extent on sectoral and large- capital vs mid / small capital funds within the equities space. Regulators brought in the aptly named ‘Risk-o-meter’ to help investors understand the risk associated with a particular scheme. However, one must realise that while risk is important, it is not the only differentiating criterion for asset allocation.
Using a thorough analysis of 2021 market performance from the prism of the quantitative practitioner, we intend to shed light on the significance of recognizing style exposure in one’s investment portfolio.
As a corollary, the next step would naturally be to focus on making active allocation decisions with regards to the same.
To be fair, a few financial portals already do classify fund offerings based on a matrix of Market Cap vs. Style exposure. However, this approach has not garnered enough mainstream attention yet.
What is Asset Allocation?
Simply put, it is the allocation of an investor’s portfolio amongst a number of asset classes. To start off, in order to make such a generalization, the first step is to define the asset classes.
Once defined, this information can be aggregated to determine the investor’s overall effective asset mix. If it this is not in-line with the desired mix, appropriate changes can then be made.
How does style fit into the Asset allocation decision?
If we stick to allocation within equities, then various research papers in developed markets and anecdotal evidence in our market has proved that much of the performance variation i.e. outperformance/ underperformance can largely be attributed to three key dimensions –
1. Cap Exposure: Large / Mid / Small Cap
2. Sector concentration / diversification
3. Value vs. Growth
The third dimension can be expanded to value, growth and quality in our markets. If we look at 2021 for instance, below is the performance of the underlying styles through time.
Main takeaways from longer term analysis include-
1. Aside from 2021, value experienced a few volatile years
2. Quality was the better performing style, especially in the first half of the decade which moderated over the second half
So what are the learnings?
This cyclically in style performance has also been attributed amongst other things to macro environment.
Growth, for instance, has been perceived to be rewarding during low volatility and benign interest rate regime.
On the contrary, value has been known to do well during high volatility and increasing interest rate environments.
However, to time this cycle is difficult for the retail investor and is akin to trying to time the markets. Instead, a better approach would be to stay disciplined through the cycle.
Like investors emphasize on allocating percentage of their wealth to equities, fixed income etc., they should also evaluate style exposures in their underlying funds, irrespective of the market cap or sector bias and diversify accordingly. If not, then there is a danger of over representation of a particular style in their portfolio, as each of these styles go through their own performance cycles.
Lastly, these styles represent the basic building blocks of investment philosophy and while they may experience long periods of out(under)performance, all of them will continue to drive the markets globally.
Karthik Kumar is a portfolio manager at Alternative Equities, Axis AMC.
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