imgbd CEO Speak

3 pillar model promises superior dynamic asset allocation

Chandresh Nigam, CEO, Axis MF

13 July 2017

In a nutshell

Axis MF's new Dynamic Equity Fund adopts a 3 pillar model as opposed to the conventional P/E based approach to asset allocation, which its back testing establishes offers a superior investment experience as it blends fundamentals with market technicals as well as market risk parameters, to allow more dynamism in the asset allocation decisions. Chandresh discusses the critical behaviour gap this product category addresses - the gap between product returns and investor returns and why the 3 pillar model is more relevant for dynamic asset allocation funds than a uni-dimensional fundamentals based one.

WF: What is your 3 pillar model for asset allocation and in what ways do you think it is superior to a simple P/E based model?

Chandresh: Before I answer the specific question, I would like to provide some context to the rationale and importance of this product and this category. We have done an analysis of actual investor flows into equity funds at different stages of market cycles and its impact on actual returns that investors make from equity funds vs returns generated by these equity funds. There is a significant gap between these two - and it boils down to inefficient allocation decisions perhaps driven by emotions rather than rational thought processes.



The whole rationale for this category of funds is to try and bridge this gap - to try and find ways in which these asset allocation decisions can be taken more on the basis of fundamentals and less on the basis of sentiments, so that the investor's experience with the investment is a lot happier.

Traditionally, one of the ways this is done is to have funds that allocate in equity markets based on the prevailing market P/E level. We believe that while P/E is a good long term indicator of value, there are other important factors too which drive the medium term direction of markets, which need to be taken into consideration, in order to have a more holistic approach towards the equity allocation decision.

We have added a couple of more medium term factors as an overlay to the market P/E, in this context. One is the market trend. So, for example, even if market P/E is currently looking expensive from a historical perspective which would normally warrant a steep cut in equity allocation, we see the market trend still quite intact, and none of the trend indicators - like Rate of Change, Moving Averages etc - are really suggesting an imminent trend reversal. This would then influence, from a near term perspective, not to cut down equity allocation to the level that a pure P/E model would otherwise suggest.


One important aspect of trends from our perspective is that we will be looking at short term (15 days) and intermediate (90 days) directional trends, with a view to resetting equity allocation once in two months. So, its not as if we will be "trading" a trend, its more about using directional trends as another indicator that determines the equity allocation.

The third aspect is capturing market risk in our decision making - through volatility measures. Whether you look at the F&O market or you track implied volatility - getting a sense of increasing volatility does give you a signal of heightened market risk - which then influences a cut back in equity allocations.

We have done back testing of our model over a 18 year period and have in fact run this model live since the last 4 years. We have clear evidence that adding the two dimensions of trend and volatility significantly aids superior equity allocation decisions, which in turn enables much healthier performance - in terms of returns as well as managing volatility of these returns.


Lastly, a single P/E based allocation model in our view does not capture the need to be a little more nimble, more dynamic in equity allocation, in response to evolving market conditions. With our three pillar approach which considers fundamentals as well as market dynamics, we are in a position to be as nimble as required, without becoming a short term trader, to capture opportunities as well as manage risk in a dynamic market.

WF: Can you take us through how the current asset allocation would be arrived at in your model - starting from where the conventional P/E pillar would suggest and then walking through how that number finally evolves into the model's number as you go through the other 2 pillars?

Chandresh: Our model today is indicating a 50% equity allocation. The range over the last 18 years for this model has been a low of around 30% and a high of over 90%. Now perhaps a purely P/E based model which looks at the current market P/E which is upwards of 20x on last year's earnings, would suggest a sizeably lower equity allocation than 50%. Our model recognizes the relatively rich market valuation but at the same time also considers the medium term trend as well as currently low levels of volatility, to come up with an equity allocation of 50%.

WF: As your presentation suggests, model based asset allocation funds generally tend to underperform during an upcycle but have the potential to deliver better results over a market cycle. Given that we are now witnessing an uptrend, how should one manage investor expectations when near term results may well be below market returns?

Chandresh: Very good point, and that is one of the key messages that we want to put out to distributors and investors. As our slide on performance in different market scenarios shows, one should expect relative underperformance of this model (or for that matter any model based asset allocation fund) vs market during sharp market upmoves, but over the long term as well as in most market phases other than sharp upmoves, the model has delivered much better returns than the market. What needs to be emphasised is the long term nature of this product and its suitability to help investors stay invested through market cycles, without worrying about market timing, because the fund is geared to dynamically change equity allocation on the basis of sound logic rather than emotions.


The good news is that industry data is suggesting that retail investors are taking a longer term approach to equity funds, which would then mean that they stay invested in a dynamic equity allocation fund for long enough to actually experience its true benefits.

WF: Does the timing of the launch of this fund suggest some circumspection about market valuations and therefore a desire to help investors get some protection from possible corrections?

Chandresh: Not at all - this product has been awaiting regulatory approval for a very long time. Had we received the approval a year ago, we would have launched then. We received the approval now, we are launching now. This is an all weather product, there is really no good or bad time to invest in it - and therefore there is no good or bad time to launch it.

WF: Should advisors whose client portfolios have sizeable unrealised gains in equity funds (which are not part of goal based plans) recommend a switch to dynamic asset allocation funds as a strategy to lock in gains and yet participate meaningfully albeit not entirely in the market?

Chandresh: Absolutely. When you are rebalancing your client portfolios, you must consider dynamic asset allocation funds as a great way to achieve this rebalancing.

WF: Your equity funds have weathered a spell of underperformance in recent times. What went wrong and how are you putting this piece back on the rails?

Chandresh: Our philosophy has always been investing in quality businesses. We have seen in the past 20+ years, quality businesses outperform weaker businesses over the long term as well as on a Y-o-Y basis for most years - barring a handful of exceptions, where relatively weaker businesses lead the market. 2016 was one such year where relatively weaker businesses played catch up and more - and that resulted in relative underperformance of our funds, since we stuck to high quality and continue to stick with that conviction. Then came demonetization towards the end of 2016, which impacted consumption oriented stocks very significantly as cash for consumption suddenly became scarce. Since our preference has been towards strong franchises which generate sustainable and growing cash flows - which generally tend to be in the consumption oriented sectors - our portfolios took a beating.

As a fund house, we operate on our strong convictions. We don't as a philosophy run one fund on one conviction and another on something else. So, we don't have one fund that believes in sticking to quality and another that disregards quality in the quest for staying with market momentum. Result was that in a year when quality took a temporary backseat, our entire range of equity funds underperformed.

We consciously did nothing to change either our approach or our convictions, and in 2017, when markets have come back to steady state, we see quality once again outperforming and consequently, our funds back into outperformance territory. So, there is really nothing we did this year, except reiterate our conviction that quality always wins in the long term for sure as well as in most medium term time frames as well, if not all.

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