How to build a volatility-proof portfolio3 min read . Updated: 15 Aug 2020, 10:13 AM IST
- The year 2020 will be remembered as the year of volatility
- Good investors are those, who instead of trying to predict volatility, prepare volatility proof portfolios
The year 2020 will be remembered as the 'Year of Volatility'. As citizens have tried to dodge COVID-19, cyclones, and locusts, among other things, markets have seen sharp equity crashes, squeezes in the bond market, and then, an almost unfathomable rally from April to June. Volatility is never easy to handle, and harder so in a world of too much information. Unfortunately, volatility is also a reality of investing – a feature, not a bug as we say in software parlance, and good investors are those, who instead of trying to predict volatility, prepare volatility proof portfolios. There are many ways to do this, but my favourite is the BAF (Balanced Advantage Fund) (or DAAF - Dynamic Asset Allocation Fund), and there are three reasons why.
The first is that its objective to protect downside is underrated. Losing money hurts, much more than making it, and it should, because if you lose 20%, you need to make 25% to recover your losses. Even worse, if you lose 50%, you need to earn 100% to earn back your capital. Losses are the blackhole of investing. The more you lose, the deeper you fall into the well, the harder it becomes to come out of it. Balanced advantage funds help contain the size of losses. BAFs hold both equity and debt, and shift between them based on a model. The model could be a trend based model that sharply cuts exposure during a fall, or a valuation based model that holds lower equity levels at peak valuations, but this dynamic management of equity exposure does protect downside. The average BAF/DAAF Category fell -13.1% in the market fall of March, compared to -23% for markets, a testament to this downside protection.(Data is average of all BAF/DAAF returns in the month of March. Source: ACE MF. Past performance may not sustain)
The second reason BAFs have significance, is that we underestimate what volatility does to returns. Most of us know the irritation we experience from bad roads day to day lives. It may not really matter every day, but it builds up over time, and damages our car. Volatility is like a bumpy road for returns. Let’s take a simple example of three scenarios, repeated for 10 years.
1) Up 20% one year, down 10% the next year
2) Up 30% one year, down 20% the next year
3) Up 50% one year, down 40% the next year.
They look the same, but they aren’t. Your compounded return in Scenario 1 is 3.9%, in Scenario 2 is 2.0%, and in Scenario 3 is -5.1%. Volatility drags returns, and BAFs reduce volatility. The volatility (standard deviation)of the average BAF/DAAFcategory over the last 5 years has been 12.62%, compared to a NIFTY volatility of 18.56%. (Data is average of all BAF/DAAF returns in the month of March.Source:ACE MF, Past performance may not sustain)The lower volatility has helped compounding, and as a result, over the last 5 years, BAFs, despite holding only 50-60% equity on average, have delivered reasonable returns compared to broader market returns.
Finally, BAFs help manage investor behaviour. Multiple studies show that investor returns on average are significantly less than market returns because of the behaviour gap, and this difference is magnified in market extremes. Extremes and volatile times bring out the worst of investor behaviour – redeeming at lows, investing at peaks, following the herd. Investors often ask me, why they need a BAF to manage asset allocation, when they can do it themselves. My answer is that they CAN, but they DON’T because emotions enter the picture. Automated asset allocation is a hedge against emotions.
Investing is not as difficult as it sounds, but a few basics are important, and staying invested through cycles is the most important one. My single biggest learning in 2008, is that low volatility investing helps you stay invested, and in fact, I’ve been a happy BAF investor for many years. I hope to see a day when the BAF class, which is large globally, is the size of the current equity MF assets. The mutual fund industry not only needs to expand its investor base, but also keep expanding their time invested, and BAF is a step in this direction.
(The author is the MD & CEO of Edelweiss Asset Management)