Opinion | How To Allocate Between Market-Based And Contract-Based Investments

The conventional approach to portfolio allocation is about asset classes such as equity, debt and alternates. The basis of allocation is the historical or expected risk-return profile of the investment, to suit the profile of the investor. This approach is well-founded, but there can be a tweaked version of this approach too.

Returns from any asset category like equity or debt is based on market movement. The market upside or downside will be of varying degree, which is why the allocation is done, to make it balanced. As against this, there are certain plain-vanilla investments, where your return is defined, like in a contract. You would not earn anything more than what is defined, but you have certainty and peace of mind, to that extent of your portfolio. Examples of contractual return deployments are bank deposits, bonds and post office deposits. For high networth individuals (HNIs) or mass affluent investors, there are certain market-linked debentures (MLDs) with high certainty of returns which may be categorized under such instruments. The requirement for contractual return investment avenues stems from the fact that there is an expectation among investors of straight-line returns. For example, if the expected return is, say, 8% per year, after six months, the investor wants to see a 4% return in the statement. Market-based avenues are marked to market and returns after six months would be higher or lower, as per market movement. You have to make up your mind on what extent of your portfolio you can spare for the long term, without bothering about the interim returns, for expected higher returns.

Market-based avenues include equity shares, equity-oriented mutual funds and portfolio management services (PMS). Debt-oriented mutual funds are market-based, since open-ended funds deliver as per the movement in the underlying secondary market. There are some avenues that provide a combination of known (contractual) returns plus some upside. If you invest in real estate and put it on rent, the market upside is yours. There are Sovereign Gold Bonds (SGBs) with a committed return of, say, 2.5% plus the market upside on gold prices. For HNIs, there are certain MLDs with a minimum committed return plus equity market upside.

The rationale for putting your money into various baskets like equity or debt is that when one market is volatile, the other is expected to be stable, so that your portfolio is not impacted as much. Historically, equity and debt have a negative correlation, though not 100% perfect, which helps your portfolio by balancing out. The reason for the negative correlation is that theoretically, when the economy is doing well, equity prices move up, interest rates move up and bond prices come down. When the economy is delicate, equity prices ease, bond interest rates ease and bond prices move up. However, the negative correlation does not always hold good; it may so happen that both the markets are moving up or both are tanking, based on market participants’ reading of the situation. Over the long term, these movements tend to ease out and you get something around the expected returns.

For portfolio allocation, in most cases, advisers recommend higher allocation to market-based investments like equity or equity-oriented mutual funds, though they are subject to relatively higher market volatility. The reason is, over the long term, equity provides better returns along with the growth of the economy. Debt-oriented mutual funds offer relatively stable but moderate returns. We mentioned debt mutual funds and not investments directly into bonds as it may not be feasible for you to manage an active debt portfolio. The risk profiles of investors vary. To the extent that you want to insulate yourself from market volatility, you would like to lock in returns through contractual investments. One important aspect of contract-based investments is credit quality. While you are moving away from market volatility risk, you may be unwittingly giving in to credit risk. In equity investments, there is no repayment from the issuer, hence there is no credit risk. Government-oriented investments such as RBI Savings Bonds, SGBs and post office deposits are completely safe. Bank deposits in public sector banks and leading private sector banks are safe. For bonds or debentures, if you intend to hold till maturity and make it a known-return investment, it is better to stick to highly rated bonds from PSU entities or well-known private sector business groups.

To conclude, the component of your portfolio you would like to detach from market volatility can be deployed in contractual-return avenues. The longer-term deployment can be put in equity so that the time horizon tides over the interim volatility. The relatively-lower-risk but market-oriented investments can be put into debt mutual funds.

Source: https://www.livemint.com/mutual-fund/mf-news/how-to-allocate-between-market-based-and-contract-based-investments-11574846908585.html

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