Backtesting Asset Allocation

Asset Allocation is the cornerstone of every investor. A good asset allocation is something that allows you to comfortably sleep at night. A bad asset allocation on the other hand gives you heartaches with higher volatility while not exactly meeting your goals either.

When it comes to basic asset allocation, you can go in two ways – the fixed method where you decide on an split between equity and debt and keep it that way by re-balancing once a year or go the tactical way with your asset allocation dependent on other factors – how cheap or expensive the market currently is for example. The Portfolio Yoga Allocator is a tactical asset allocator.

These days I find asset management companies pushing towards Hybrid funds as a way to smoothen the volatility. A few years back, the same funds were being pushed as a superior investment owing to their continuous dividend paying policy which provided cash flow to the end customer. When the markets change, I change my Narrative. What do you do, Sir 

Across fund houses, as on date we have 180+ schemes that match the Hybrid / Balanced fund category managing over 3.8 Lakh Crore. The wonderful part of the whole equation is that they charge asset weighted around 1.65% for the pleasure of providing you some level of asset allocation split.

While the choices are many, just 28 of the 180+ schemes account for 80% of the total assets under management with HDFC Balanced Advantage Fund being the biggest of them (11.6% of total assets).

In the United States, Vanguard offers portfolios with fixed asset allocation split with expense ratio being below 0.10%. Interestingly you can devise your own fixed asset allocation portfolio here in India with the end cost being just around what Vanguard is providing its US clients.

SBI ETF that tracks Nifty 50 for example has an expense ratio of just 0.07%. While there has been Liquid Bees that has been in existence for long, Axis Liquid with assets under management of nearly 30 thousand crores and expense ratio of 0.11% is just as suitable.

Our goals are dependent on the future growth of our portfolios and while fund managers talk about high expectation of return, I for one felt that looking at the past data should provide us with a clue on what we should expect in the future.

For this exercise, I have chosen Nifty Bees as proxy for Equity and HDFC Liquid Fund as proxy for Debt. Portfolio’s was created in January 2002 and rebalanced once every year. The rebalance was subject to a variation of 5% from our target allocation. For instance if Equity shot up during the year and we ended the year with 65% Equity and 35% debt vs starting point of 60% Equity and 40% Debt, the additional equity is sold off and used to buy Debt to bring it back to the 60/40 ratio.

60 – 40 (Equity – Debt) Rolling CAGR

First up is the predominant asset allocation split. 60 / 40 is universal & the simplest asset allocation with a slight tilt towards equity. Do note though that since we have 60% in equity which is of much higher volatility than debt, if you were to measure the asset allocation in terms of volatility, this would seem more like a 80 – 20 split.

As on date, the 3 Year CAGR for this mix comes to 11%, its 7% for 5 years and 9% for 10 Years.

We measure risk by looking at the composite draw-down of the portfolio from the peak. As the chart below shows, most of the time the draw-down was limited to 10% or lower with the maximum being seen as expected in 2008 when markets dropped more than 50% and this portfolio dropped around 25%

Inverting the Ratio – 40 – 60 (in favor of Debt)

What if we tilted the ratio in favor of Debt vs Equities. How would that impact the returns and the Risk?

The chart below plots the same and as can be observed, the difference is minor. But do note that compounding on the long term can meaningfully change the end values for a 60/40 split vs a 40/60 split if the equity premium continues to remain strongly positive.

With Equity taking a back-step, we see a slight reduction in the draw-down as well. 14% is something one can live with given the rarity of such events.

The Aggressive Investor – 80 – 20 Split

If you are young with limited savings and a long road ahead, you may opt to be aggressive when it comes to equity allocation. While you can always go with a 100% allocation to equities, given the uncertainties in life, having a small allocation to debt can help during the bad days.

There is no free lunch and a 80 – 20 Asset Allocation also has a higher draw-down and higher volatility. But at the right time, high allocation to equity can boost your returns significantly.

The Reluctant Investor, 20 – 80 Split

But what if on the other hand you are retired and dependent on the savings for the rest of your life. You wouldn’t want to take unnecessary risks. Yet, with dropping interest rates, it does help to have a small allocation to Equities that can push up the overall returns in good years while not dragging them down substantially in bad years.

Thanks to the fact that our equity exposure is just 20% and one that is re-balanced regularly to keep in shape, the draw-downs is something you can sleep comfortably with even when the rest of the world is seemingly jumping off the ledge.

Asset Allocation is specific to each individual, this goals and his risk taking capacity. While we all wish for the largest gains, we cannot easily digest the large draw-downs that occasionally come with it.

Panic is certainty for everyone of us, but with the right allocation rather than panic we can take advantage of the opportunities provided by the market.

Before I conclude, lets take a look at the Equity Curve of all the above allocation strategies. It goes without saying that higher the equity exposure, better the end result.

One observation from the data is that returns are trending down for a long time now. While the future maybe bright, this data to me provides a perspective on what is possible and what is not.

Compared to fixed, I continue to believe that tactical can provide you with a larger advantage but since its requires monitoring of a regular nature and one can go wrong as well, its not everyone’s cup of tea.

Hope this post provides you some food for thought on how to approach your asset allocation from the perspective of future returns. If you have any queries, do drop me a mail or comment below.