Resetting the returns expectations

It is important for investors to realise that nominal returns could come down and expectations should be lowered


The recent demonetisation announcement coupled with Donald Trump’s presidency shook the Indian markets. While equity markets tumbled (Nifty fell by 7-8%), bond markets rallied, with the 10-year government security (g-sec) yields dropping by almost 50 basis points (bps) in the 9-21 November period and hence, bond prices moved up by almost 3-4%.

Whether the economy and the equity markets will bounce back after the initial shock, or we could see an extended slump, is a hot topic but we won’t discuss that here. What appears clearer is that lower interest rates and lower inflation are here to stay, helped by a combination of huge liquidity in the banking system and still weak aggregate demand. From an investor’s perspective, this is possibly the most critical variable.

Indian investors are not used to low rates. The only period when rates declined was in 2001-03, when g-sec yields declined by almost 600 bps. That also was a period of declining rates, not steady low rates. In a declining rate scenario, bond prices do well and hence one can shift portfolio towards bond or g-sec funds. The latter gave more than 25% compounded annual growth rate over 2000-03. However, when rates are low but flat, bond funds will also give single-digit returns.

The equity markets obviously have more variables but, simplistically, if one adds equity risk premium of around 5% to the g-sec yield of 6-6.5%, then equities should return 11-11.5%. Looking at it another way, if gross domestic product (GDP) grows at 7%, and inflation is at 4%, earnings growth could be at 12-13%. With price-to-earning (P-E) multiples already at above average (especially for mid- and small-caps), significant P-E expansion looks unlikely; and equity returns could be in the range of 11-13% over the next 2-3 years. The obvious caveat here is that if economic growth picks up significantly, returns could be higher, or vice versa. These returns compare poorly with the returns of 15-16% the past 3 years.

Though nominal returns might appear lower than previous years, they are based on low inflation, and hence real returns would still be comparable to previous years. But investors must realise that nominal returns can come down and expectations should be lowered.

In my interaction with investors, I find that their benchmark is still the past performance, and many advisers or distributors are extrapolating those returns. The 2013-16 period was possibly the best for Indian equities in a decade. It started off from a low base of August 2013, and was helped by favourable elections and high inflows from foreign and domestic investors alike. Expecting a repeat of that performance, especially from the current not-so-cheap valuations will be a stretch, even more so in the light of likely near-term growth bumps.

In equity, the timing of investment becomes critical as investing in times of low valuations (2013) can enhance your returns, and vice versa. Investing systematically through, say, systematic investment plans (SIPs) mitigates the timing aspect to some extent, but not fully. Even through an SIP, it will possibly make sense to top up when valuations are low. The importance of appropriate asset allocation is critical at all times, but even more so in such an uncertain environment. Taking the example of the past few days (8-21 November) itself, a mix of debt and equity funds would have yielded better returns and with lower volatility. Yes, that period was exceptional, but even over the longer term, a mix of bonds and equities lowers the volatility considerably, while not impacting the portfolio returns that much. So, a 30:70 mix of debt and equity funds over last 5 years would have still yielded 16% compounded annual growth rate (CAGR) versus a pure equity fund portfolio of 20% CAGR , but with significantly lower volatility of 0.09 versus 0.15 of an equity portfolio. And this includes the best period for equities in a decade. As many studies have shown, the biggest determinant of portfolio performance (80-90%) is asset allocation and securities selection, i.e., choosing the right fund or stock plays a minor role. But most investors spend time in trying to get the best performing fund or stock.

A balanced fund performs the asset allocation task, but not completely. For one, its equity:debt ratio varies with the market or fund manager’s view of the market, while asset allocation should take into account investor preferences too. Secondly, all investors have the same mix. Also, many balanced funds carry more of mid-caps and small-caps in their equity portfolio, which can increase their volatility. Asset allocation becomes even more important in a low-interest environment as there is a tendency to shift towards seemingly high-return products (equity) when returns in fixed-rate instruments are falling. Many advisers are pitching high equity allocations to even risk-averse investors to make up for lower rates on deposits.

Asset allocation should be more a function of an investor’s risk appetite and life stage, and less a function of the market environment. In today’s environment, equity allocations would have risen due to better performance and it will be in an investor’s long-term interest to pare equity allocations so as to maintain an optimum mix.

Atul Rastogi is an investment adviser and founder

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