4 factor model drives optimal asset allocation decisions

Anthony Heredia

Chief Executive Officer

Baroda Pioneer AMC

  • AnthonyHeredia
  • The new Baroda Dynamic Equity Fund employs a 4 factor model to drive optimal asset allocation decisions between debt and equity (all trailing basis):
    • PE(x) (proxy of P&L)
    • P/BV (proxy for Balance sheet)
    • Dividend Yield (proxy for cash flow)
    • Earnings yield gap (proxy for equity risk premium)
  • Minimum net equity level set at 30%, fund will currently be less than 40% equity in its initial portfolio
  • Bullish currently on rural consumption theme and in terms of sectors, private sector banks, IT, pharma and select consumer non-discretionaries

WF: Is the timing of this fund launch influenced by recent heightened volatility in markets?

Anthony - We have been working on the model for the quite some time . Many fundamental parameters were considered before finalizing on PE(x), P/BV, Dividend yield and Earnings yield gap. Based on the fundamental parameters chosen, the results were optimized by differing weight for the factors.

Finally, back-testing of data was conducted for various levels of minimum equity exposure before zeroing down to minimum 30% equity.

It is coincidental that this product is ideal for current volatile markets. However, we have observed that this model is effective across market cycles- barring when there is a sudden sharp upward movement in the market. As the duration of the investment increases, the probability of outperformance also increases. With a 5-year time horizon, the likelihood of achieving the investment objective increases.

WF: What is the model that will drive asset allocation and how much flexibility will the fund manager have to influence this? Is there a range that the model provides or an absolute mix?

Anthony - The two main asset classes that this equity oriented fund will invest in are equity and debt. The model considers 4 fundamental valuations (on trailing basis) parameters:

  • PE(x) (proxy of P&L)
  • P/BV (proxy for Balance sheet)
  • Dividend Yield (proxy for cash flow)
  • Earnings yield gap (proxy for equity risk premium)

This fund will have a very rational approach towards equity allocation without having any behavioral bias by the fund manager. The model will throw up the equity allocation. Fund manager will have a leeway of +/- 2% to deviate from the model. This leeway is more for operational reasons and to protect the unit holders’ interest rather than to generate outperformance.

WF: You have the leeway of going upto 100% on the equity exposure – what will be the equity exposure that you aim for this fund during the initial cast of your portfolio?

Anthony - The fund can take an equity exposure that can go upto 100%. Back testing of model shows that the highest equity exposure of the fund is a shade over 95%.

Despite the sharp fall in the market, the equity allocation (as on 25th September 2018) is expected to be less than 40%.

WF: What is the ideal market cap mix that you intend to achieve in the equity portfolio? Also, in the initial cast of your portfolio, which sectors are you likely to consider and which ones would you avoid given the current macro scenario?

Anthony - Approach to equity investment will be multi-cap. It will be diversified across various sectors and stocks. Given the current market scenario, we are more inclined to large caps. In terms of investment themes, we continue to like rural consumption and retail private sector banks. In terms of sectors we continue to like IT, Pharma and non-discretionary consumption selectively.

WF: How will the debt component of this fund be managed?

Anthony - Debt portion will be actively managed- across duration and credit. However, given the current liquidity scenario, we are likely to be only at the short-end of the curve. Given the risk, we may not take any credit given the current pricing.

Key determinant of success of the fund will be by the equity allocation decided by the model. Outperformance by the equity or debt portion will play a marginal role in outperformance.

WF: How should distributors contrast between dynamic equity funds and balanced advantage funds and determine their respective suitability for investors?

Anthony - Baroda Dynamic Equity Fund is the same as most other Balanced Advantage Funds in the market. The fund is categorized under dynamic asset allocation / Balanced Advantage fund as per SEBI’s circular on product categorization.

This product is worth considering primarily due to the proprietary model we have developed to decide on allocation between various asset classes . Our model takes PE, PB, Dividend Yield and Earning Yield Gap into consideration to decide on allocation between Equity , Arbitrage and Debt, and has been back tested extensively to verify that the model achieves its desired outcome.

This fund can be a core investment and is suitable for all investors who are looking to invest in equity for the long term across market cycles, as the product is designed to adjust its equity exposure depending on market conditions.

WF: How do you seek to differentiate your fund in this category?

Anthony - Baroda Dynamic Equity Fund considers 4 fundamental factors to determine the equity allocation. Multiple valuations parameter encompasses various facets of the company-P&L, Balance sheet, cash flows and equity market risk premium. Further forward valuations are not considered. Hence, the tendency of bias is eliminated completely. The weightage that will be assigned to each of the parameters have been back tested to optimize the return.

Finally the re-balancing on monthly basis has been optimized to ensure smoother allocation to equity and not lose out on transaction cost.

Disclaimer : Mutual fund investments are subject to market risks, read all scheme related documents carefully.

The above article only seeks to provide information to readers and does not in any way seek to solicit or advise readers to invest in any scheme of Baroda Pioneer Mutual Fund. Past performance and any forecast is not necessarily indicative of the future or likely performance of any scheme of Baroda Pioneer Mutual Fund. Opinions expressed herein are subject to change without notice. Baroda Pioneer Asset Management Company Ltd., Baroda Pioneer Mutual Fund and/or its sponsor are not liable for any loss caused to any investor due to reliance on the above article. Readers are advised to consult their investment advisers / tax consultants on the implications of investing in mutual funds.

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