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Keep Faith In Equities

Fabled British economist John Maynard Keynes had famously said once “When the facts change, I change my mind. What do you do, sir?” To paraphrase him a bit, we ought to be asking ourselves a similar question “When the economic climate changes, I change my investment strategy. What do you do, sir?”

A lot has changed for Indian economy in last one year. Much of this change has been adequately covered in media. We need to turn now to changing our investment strategy sufficiently to reflect these changes. The high level one-line summary of “go overweight on equities” is a good starting point – though by no means a sufficient shift in the strategy. This article covers a few areas that require attention.

1. Overweight equities, even get equal weight to start with

The most obvious change in investment strategy as noted already is to increase portfolio allocation to equities. Enough has been written about the rationale for this. Hence I would focus instead on the allocation levels. Many investors held on to their loss-making equity investments through 2012 and 2013. For them the correct decision now is to hold on instead of breathing a sigh of relief at having recovered your principal amount and exiting while you still can. We are very likely standing at the beginning of a major bull run and it would be counterproductive to exit now only to re-enter it under the influence of euphoria and probably at twice the valuations!

Some investors had stayed out of equities through 2011-14 – either by design or by luck. Many of them are not sure when to really get back in. For them it is not even a question of going over-weight on equities, it is simply being “equal-weight”. Similar argument as above applies to them as well – best not to time market levels – a simple systematic transfer plan can guard against any concerns of getting entire equity allocation done at a single date.

We are very likely standing at the beginning of a major bull run and it would be counterproductive to exit now only to re-enter it under the influence of euphoria and probably at twice the valuations

2. Sector preferences for cyclical’s instead of defensive’s

For somewhat savvier equity investors, preferred sectors through 2012-14 have been defensive bets such as FMCG, Pharma and IT. While these sectors are likely to continue performing well through the broad market upward movement, others like auto, capital goods and banking are likely to outperform them on the back of the revival in investment cycle. It is probably a good time to revisit sector allocation of direct equity investments.

3. Long term debt – party’s getting over

Many investors had made specific bets on fall in yields on G-Secs on the back of loosening of monetary cycle. RBI postponed its rate cuts till earlier this year owing to persistently high inflation – but the rate reduction seems to be here to stay now. In light of this the yields on G-Secs have already come down a fair amount. While they might continue their downward journey, the big part of this movement is behind us. Hence the investment into long term G-Sec mutual funds for capital gains over and above the carry has more or less played out now. It would not make a lot of sense to invest afresh into long term government debt with an eye on capital gains. Existing investments into these instruments can be gradually exited over this calendar year.

4. Liquid funds will no longer be a good default option on debt side, arbitrage funds are better due to tax efficiency

Due to the ongoing loosening of monetary cycle by RBI the general level of interest rates in the economy is falling. This is still as visible in the returns of liquid funds as it would be after one or two years. Till recently, most investors used liquid funds as a default parking vehicle for their savings. As interest rates come down, this would no longer be very remunerative. Investors will need to look for alternative avenues to allocation low-risk debt part of their portfolio. This becomes all the more necessary in light of the changes in tax treatment of debt funds in general – with definition of long term for debt holdings being increased to three years from earlier one year period. Arbitrage funds provide an useful and tax efficient alternative to short term debt funds in this context.

5. Lock in good interest rates with credit investments for 3-5 years’ tenor, FMPs no longer serve this need well

Most investors used fixed maturity plans (FMP) to invest their medium term monies into debt through the last few years. FMPs routinely offered annual rates near 10% till last year. Increasingly these have started to come down. Also tax the treatment mentioned in Point 4 means FMPs are no long superior to non-convertible debentures (NCD) and fixed deposits (FD). At present, with the expectations of reducing interest rates, investors would do well to lock in good interest rates of NCDs and FDs. Depending on the appetite for credit risk, suitable NCDs with ratings varying between AAA to BB can be picked up with tenors of 3-5 years.

The investment demand for gold from global institutional investors seems to have tapered down quite a bit. While gold may still deliver good returns in the years to come, it’s day under the sun is well and truly over

6. Beware of holding a 5=years plus product – PE, equity closed ended funds

A common mistake during a bull run is to invest into products which have a long lock-in and extend well into the later parts of a business cycle. Generally when the time for exit for such products comes, the mood in the economy and the capital markets might have already shifted so much that the returns realized become quite poor. It is hard to predict the length of a business cycle. However, investing into products with horizons longer than five years is quite hard to justify in most cases.

7. Gold Is Over. US Equities Are The New Gold

Investors in gold enjoyed a decade long bull run up to 2013. In this period, the returns on gold outstripped those from any other major asset class. Many investors armed with this, post facto, declared their prescience about real assets being safer than paper assets! In reality, gold was benefiting from a combination of rising middle class in India and China and the sharp rise in gold ETFs in the years of major liquidity around the global financial crisis. It would be imprudent to make any generalized statement about the future of gold. Clearly the consumption demand from retail buyers in India and China is there and is quite strong. The investment demand from global institutional investors though seems to have tapered down quite a bit. While gold may still deliver good returns in the years to come, it’s day under the sun is over. Its returns would probably match its risk (volatility in price and major falls) now on.

What should investors do to have a hedge against Indian equities under performing if not invest in gold? To some extent US equities could perform this role. The volatility of US equities is much lower than that of Indian equities and being a much deeper market, it is less prone to liquidity shocks. The US equity markets do poorly only in times of extreme global risk aversion. Indian equity markets on the other hand can under perform even if there is scare in the Eurozone and global investors reduce their allocations to emerging market equities. US equities also have the benefit of being dollar-denominated and hence being a good hedge against a sharp fall in the value of rupee in case global capital flows to India reverse direction.

To summarize, investors need to move from investing predominantly in a combination of liquid funds, FMPs, long term G-Sec, defensive stocks and gold to a combination of NCDs, arbitrage mutual funds, credit funds, diversified equities, cyclical sector stocks and US equities.

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