Would you pick a cricket team with only 11 top batsmen? Absolutely not. Your team wouldn’t be able to bowl out the opposition. Would you have the same team play in tests, ODIs and T20s? Probably not because not all players are suited for all formats and may not adapt to varying playing conditions essential for winning. Similarly, investing in a single asset class such as Indian equity or debt or gold or real estate may not be suited to varied market cycles and may not help achieve one’s financial goals.
Each asset class has its own risk and return characteristics due to which its performance varies in different market conditions. For instance, equities are volatile over short-term periods but carry the potential to generate superior returns over the long term. Within equities as well, risk and reward varies across segments such as large-, mid- and small-cap or domestic and international markets. Mid- and small-caps carry higher return potential but tend to be more volatile than large-caps. Similarly, emerging market performance fluctuates more than that of developed markets. Debt performs well in a softening interest rate environment and importantly acts as a cushion in one’s portfolio when equities are witnessing significant volatility (for example, debt outperformed in 2008-09 during the Global Financial Crisis and at the onset of the pandemic in March 2020). Similarly, gold outshines during periods of significant economic or market uncertainty.
Multi-asset investing is about building a portfolio with a mix of asset classes that react differently to varying economic or market scenarios, thereby helping generate superior risk adjusted returns across market cycles. Going back to the cricketing analogy, it’s like building a team with a good mix of batsmen, bowlers and allrounders suited to the playing conditions and format.
Three reasons why multi-asset investing is essential:
- Diversification is key
- Reduces risk, and
- Has the potential to generate superior returns, if managed well.
Diversification Is Key
Asset class performance varies across time periods making it difficult to predict losers and winners on a year-on-year basis. The same asset classes will not be at the top all the time. Our research shows, for example, that various asset classes / markets that were winners in certain years, were losers in subsequent periods, and vice-versa. For instance, Indian equity outperformed in 2009 and 2010 but turned out to be the worst performer in 2011. When global equity markets witnessed sharp corrections in 2008, debt outshone. In 2013 and 2019, when Indian equity generated poor returns, international equity markets such as US and Europe witnessed superior performance. On a compounded annual growth rate (CAGR) basis, developed markets driven by US equities have outperformed Indian equity since 2008.
Global Winners And Losers
Why does asset class performance vary across time periods? Each asset class tends to have different economic or return drivers resulting in varied performance across time. For instance, Indian equity provides exposure to Indian economic drivers and would perform well during positive domestic economic and corporate earnings cycles and underperform in an economic downturn (for example, in 2008, 2018 and 2019). International equities provide exposure to global economic drivers and a hedge against the local currency. Depreciation in the Indian rupee improves returns for Indian investors investing into international markets. Interestingly, a multi-asset portfolio (of 40 per cent India equity, 10 per cent global equity, 45 per cent India fixed income and 5 per cent gold) hasn’t been at the bottom of the chart in any year and has outperformed several assets over time, highlighting the essence of diversifying one’s portfolio across asset classes and markets.
Reduces Risk
Indian equities have performed well over time but have encountered sharp drawdowns and long recovery periods from time to time. Drawdown is the maximum fall in the value of a security or index during market downturns. And the recovery period indicates the time taken to recover the initial value of investment. For instance, if one had invested Rs100 in Indian equities at the market peak in January 2008, its value fell by 64 per cent to Rs36 during the Global Financial Crisis and it took around 86 months to recover the initial investment of Rs100!
Several asset classes have witnessed lower drawdowns during crisis periods. Markets and asset classes perform differently, in terms of risk and return, due to less than perfect or at times low correlation of one asset versus others. In other words, asset classes don’t typically move up and down to the same extent across market cycles. This signifies that a multi-asset portfolio would cushion the portfolio during downturns compared to an equity-only portfolio by reducing drawdown risk.
Why is it vital to reduce drawdown risk? As drawdowns increase, the subsequent market performance required for recovery needs to be higher than the drawdown percentage. The table below indicates the upside needed to recover from drawdowns.
Potential To Generate Superior Returns
Research points to the fact that expected returns for asset classes vary over time in ways that are predictable, creating opportunities for investors to enhance returns. An investment approach geared toward opportunistically finding assets that are priced to deliver expected higher returns while keeping a long-term perspective is referred to as valuation-driven asset allocation. Benjamin Graham, the grandfather of value investing, said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” Said another way, markets measure sentiment in the short term, but real value drives returns over time.
Understanding the difference between price and value is an important point for asset allocators. In the very long run, equity returns are almost entirely driven by fundamentals as measured by total payout yield (including dividend yield and share buybacks) and earnings growth. This insight puts the onus of long-term investing on a deep understanding of fundamentals. Thus, the focus of valuation driven asset allocation today is to gain an in-depth understanding of the assets that we invest in.
In conclusion, successful investing can be viewed as finding assets that trade at a discount to their intrinsic value. It sounds simple, but it’s not easy. It requires a long-term mindset, a deep understanding of fundamentals, a repeatable framework for decision-making, a willingness to go against the crowd, as well as an awareness of the capital cycle.
The author is Director – Managed Portfolios, Morningstar Investment Adviser India
