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As the calendar year draws to a close, many investors will approach their financial advisers for an annual portfolio review. Do-it-yourself investors should also conduct this exercise to eliminate the excess risk that may have accumulated in their portfolios over the past year. 

 

What are some key issues in portfolios 

 

Equity exposure in portfolios is likely to have exceeded the original strategic level due to strong performance in equity markets, both domestically and internationally. 

 

Allocation to gold is also likely to have increased, as the yellow metal has also delivered robust returns.  

 

 

Investor returns appear inflated because all asset classes — equity (domestic and international), gold, and even debt (due to declining yields) — have performed well this year. “Investors need to be mindful that such returns may not get repeated in the future,” cautions Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. 

 

 

Investors who started with an original equity allocation of, say, 70 per cent may now find it has increased to, say, 80 or 85 per cent due to the rally in equities. “There is a temptation to increase their long-term equity allocation to this level. This happens whenever returns from equity markets are very high,” says Arun Kumar, head of research, FundsIndia. 

 

As in most bull runs, investors have flocked to high-performing categories like momentum funds, with new fund offerings (NFOs) stoking further interest in this category of factor funds. “Investors have entered this category without actually understanding its nature and risks,” notes Bhavana Acharya, co-founder, Primeinvestor.in. 

 

Taxation has also influenced investor decisions, especially after debt funds lost their indexation benefit. “Many investors have substituted debt funds entirely with balance advantage funds and multi-asset allocation funds, believing they are exact substitutes when they are not,” says Acharya. 

 

Rebalance in favour of debt 

 

Check how your current asset allocation compares to your original allocation. If your equity allocation has risen significantly — beyond 5 percentage points — it is necessary to rebalance. 

 

While equity and gold have outperformed, debt funds have also delivered gains due to declining yields. However, the absolute returns from equity and gold have been higher than from debt. “Rebalancing needs to happen away from equity and gold and towards debt. With growth slowing down, equity could be adversely affected, while a slowdown will most likely lead to interest rate cuts, which will benefit debt funds,” says Dhawan. 

 

Rebalancing involves selling a portion of the outperforming asset class (or classes) and reallocating it to the underperforming one. While higher equity allocation can boost returns, it also raises risk. “Equity funds can fall 40-50 per cent, or even more, during a bad year for the markets. Striking a balance between desired returns and risk tolerance is why rebalancing in favour of debt is important, even if post-tax returns from debt are less attractive,” says Kumar. 

 

Two methods: Which one works for you? 

 

Rebalancing can be done in two ways. One, investors can sell a portion of the outperforming asset classes (equity and gold this year) and reinvest in the underperforming one (debt). Two, they can direct incremental cash flows over the next year into the underperforming asset class. The latter method helps avoid taxes and exit loads. 

 

“Investors with regular cash flows can allocate money to fixed income. However, retirees or those without income, will need to adopt the first approach of selling equities and gold,” says Kumar. 

 

The choice of method should also depend on how much incremental money is available. “If it is insufficient to bring the allocation of debt back to the original level, investors should use a combination of both methods—partly selling the outperforming asset classes and partly allocating fresh cash flows to the underperforming asset class,” says Dhawan. 

 

Common mistakes to avoid  

 

Avoid altering your original asset allocation during a bull market. “Asset allocation should change only if your goals, life situation, or risk profile have changed,” says Kumar. 

 

Do not blindly replace debt funds with balance advantage or multi-asset allocation funds for tax benefits. “Some funds in these categories can get aggressive in their equity exposure. Investors must consider how such a substitution will affect their portfolio’s risk profile,” says Acharya. 

 

 

Sector and thematic funds: Should you take exposure to them? 

 

Investors poured money aggressively into sector and thematic funds over the past year 

 

Timing both entry and exit from these funds is crucial for success, but this is extremely hard to pull off 

 

Chasing recent performance in these categories is highly risky; in fact, investors need to enter sectors and themes that are out of favour, but few investors have the appetite to do so 

 

Concentration risk is very high in sector funds, as just 5-10 stocks often account for 70-80 per cent of the portfolio 

 

Even if investors get timing and fund selection right, they often allocate only a small portion (around 5 per cent) to these funds, which doesn’t significantly impact overall portfolio returns 

 

Only highly experienced investors, who wish to act like fund managers and can dedicate significant time to analysis, should have exposure to them 

 

Exposure to these funds should be capped at 10-15 per cent of the equity portfolio