Different asset classes perform differently during different times. So, an investor should invest in more than one asset class. Investing across various asset classes and products is called diversification. Let us discuss the importance of diversifying and rebalancing in detail and the ways to do it.
Diversification and rebalancing and its importance explained
Different asset classes like equity, fixed income product and gold do not move in the same direction and with the same pace at the same time. Some asset classes may see huge volatility as well as extended consolidation phase, so it is advisable for an ordinary investor to allocate his investible funds across various asset classes. There is no ideal asset allocation and may vary depending on your age, risk appetite and consistency of income.
A significant portion of performance of your portfolio is dependent on proper asset allocation at all times. For ensuring correct asset allocation at all times, it is equally important for you to review the performance of your portfolio periodically and carry out the corrective act of rebalancing of various asset classes to restore it to the desired level. An ideal asset allocation should not remain static but should be changed dynamically as the person progresses in career and in age. It may also be kept dynamic under changing market conditions. Proper asset allocation accompanied with periodic rebalancing helps you reduce the volatility of the portfolio as well as it helps you optimize the return for your portfolio.
Why an average investor cannot carry out proper diversification efficiently?
Though you can invest in various asset classes separately yourself but it is very difficult to monitor, review and rebalance the investments periodically due to your regular vocation, be it salaried or self-employed. Moreover, an average retail investor lacks the competence and knowledge to correctly gauge the future course of direction of various asset classes in near future. Since for maintaining desired asset allocation, you need to rebalance your portfolio by churning out part of your existing investments. Such churning may entail transaction costs as well as tax liability on the profits realised.
How to ensure asset allocation in a single product?
For those investors who are risk-averse or an average investor who do not have requisite knowledge as well as the time needed to decipher the direction of performance of various asset classes in near future and to execute rebalancing efficiently can invest in various hybrid mutual fund products available. Some of these hybrid mutual fund schemes come with SEBI-specified limits for investment in various asset classes. There are the products like aggressive Hybrid Funds, Conservative Hybrid Funds, Balanced Advantage Funds, Multi Asset Allocation Funds etc.
Readily available Product with established track records
ICICI Prudential Mutual Fund has an all in one product called ICICI Prudential Asset Allocator Fund of Funds which meets your requirement of asset allocation and timely rebalancing with no cost and tax implications on such rebalancing.
As the name suggests, the fund invests in various mutual fund schemes of equity, debt and gold of ICICI Mutual Fund house and carries outs rebalancing periodically based on its in-house model. Following the in-house model ensures proper asset allocation at all times. The in-house model is based on four major market indicators; PE ratio, Price to book value, Market Cap to GDP and yield gap on G-sec. The model assigns equal weight to all these components. This model gives a valuation index based on input of these four ratio. This valuation index gives signal of as to when is the right time to enter the market and when to exit and shift money to debt and gold from equity. Thus, this model ensures right asset in right proportion at the right time.
Due to automation of the process of switching and investing, the undue influence of human bias is eliminated altogether.
Due to in-built diversification across various asset classes, its risk and volatility measured by standard deviation is lower than the Nifty index. This model ensures lower risks and volatility with equally good returns of equity in the long run. As the scheme is permitted to take 100% exposure in any asset class, the fund manager has freedom to take the call to go overboard on any particular asset class at any given point of time to optimize the returns for investors.
Taxation aspect of asset allocation funds
Since Asset Allocator Fund of Funds is a fund of funds and invests in many debt and equity schemes, it does not qualify as an equity-oriented scheme and therefore you need to hold your investment for 36 months or more to be eligible for availing the benefits of indexation and concessional flat rate of 20% available on long term capital gains. With indexation the effective tax rate is far lower than 20%. In case you redeem your units before 36 months, the profits are treated like your regular income and are taxed at your slab rate.
(The author is a tax and investment expert and can be reached at [email protected])
Disclaimer: This is the author’s personal opinion. Readers are advised to consult their financial planner before making any investment.