How to Decide your asset allocation with Mutual Funds?

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How to Decide your asset allocation ?

The funds that base their equity allocation on market valuation have given stable returns in the past. Pick these if you are a buy-and-forget investor.

Small investors are often victims of greed and fear. When markets are rising, greed makes the small investor increase his exposure to stocks. And when stocks crash to low levels, fear makes him redeem his investments.

But there are a few funds that avoid this risk by continuously changing the asset mix of their portfolios. Their allocation to equity is not based on the fund manager's outlook for the market, but on its valuations.

Our top pick is the Franklin Templeton Dynamic PE Ratio Fund, a fund of funds that divides its corpus between two schemes from the same fund house-the Franklin India Bluechip Equity Fund and Templeton India Income Fund. The allocation changes every month based on the PE of the market.

This auto rejigging has ensured stable 17.7% annualised returns for the fund since its launch in 2003. This is higher than the 14.7% returned by the Nifty but lower than the 19.8% delivered by the average diversified equity large-cap fund. It also pales before the 24.5% growth registered by the average large- and mid-cap diversified equity fund during the same period. However, the 'safety first' approach helped the fund contain losses when the market was unravelling in 2008. When the market peaked in January that year and the Nifty PE hit an all-time high multiple of 27.62, the FT Dynamic PE Ratio Fund had only 30% of its corpus in the Bluechip Equity, while 70% was safe in the Templeton India Income Fund.

Valuations decide the allocation

Small investors make the mistake of entering the market during bull runs and tend to compound the error by staying away from equity when the market turns bearish. This is where asset allocation funds take the right decisions on behalf of investors. When the market tanked and the Nifty PE hit a low multiple of 12-13 times in December 2008, the FT Dynamic PE Ratio Fund had 90% in equity. Currently, the Nifty PE is 18.5 times and the fund has 61% in stocks.

Just as the FT Dynamic PE Ratio Fund looks at the index PE, the ICICI Prudential Dynamic Plan considers the price to book value (PBV) ratio of the market while deciding its exposure to equity. When the Nifty PBV crosses 3.5, the fund reduces its equity exposure to the minimum 65% it is supposed to maintain. This astute allocation has enabled the fund deliver an eye-popping 26.8% annualised returns since its launch in October 2002. Now, when the Nifty is trading at a PBV of about 3.16, the fund has about 77% of its corpus invested in stocks. This is not a view on the market, but on the valuations.

The ICICI Prudential Equity Volatility Advantage Plan is a balanced fund that works on the same principle. Launched six years ago, it has consistently outperformed its category and even diversified equity funds. In the past one year, it has given 16.6% returns compared with 7-10% by various categories of diversified equity funds. This is not a flash in the pan. In the past five years, the fund has given 7.86% returns compared with 3-5% by the average diversified equity fund.

In the past 1-2 years, other fund houses have also launched funds that base their asset allocation on the market valuation. The big advantage for the investor is that he can rest easy in the knowledge that his fund will automatically book profits when prices shoot up.

Which is more flexible?

The FT Dynamic PE Ratio Fund is more flexible when it comes to asset allocation. It is a fund of funds and can technically reduce its allocation to stocks to zero. However, ICICI Prudential's Dynamic Plan and the Equity Volatility Advantage Plan need to have at least 65% in equity.

This feature ensures that the funds are eligible for tax exemption on long-term capital gains. On the other hand, there is no exemption available to investors in the FT Dynamic PE Ratio Fund because it is a fund of funds. Short-term gains are added to your income and long-term gains are taxed at a lower rate of 10% (or 20% after indexation). Do remember, however, that there is no tax implication for the investor when the fund shifts from stocks to debt and back in a volatile market.

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