Understanding when and why asset classes perform is a homework well done

By S Naren
Chief Investment Officer (CIO)
September 09, 2014
Text Size : A A


Here are a few guiding principles one can use very effectively before one enters or exits any asset class.

Every now and then, I have been noticing many investors making needless mistakes of entering an asset class much later than everybody else when the cream of the returns are over. At other times, investors ignore obvious tell-tale signs of entering into an asset class and overlooking some investment opportunities to accumulate assets when cheap.

It is because investors may be unaware of certain conventional principles or fail to notice them. I am listing a few principles for your reference hoping that they serve you as a guide for when to buy or sell various assets. Let me add a caveat upfront, these are just guiding principles. Markets have a tendency to over react and so not all indicators are perfect. Nevertheless, they have served me well over the years and they, I am sure, will help you gain authentic insight into how asset classes generally perform in all market conditions. Here they go.

Going for assets that have done badly

It is better to invest in an asset class that has done badly than to invest in an asset that has done well in the past 1-2 years. One must also avoid buying an asset class that everyone else is buying. It is better to invest in equities as an asset class when they have been under-delivering i.e. making negative returns of say -20 or -40 percent in the past one year. This gives investors reasonable buying opportunities at discounted prices.

We have seen that happening in the Indian equity markets very often in the past. For example, during 1995-2002, equity markets gave 0% returns. Pessimism prevailed; everybody felt equities would never deliver returns. Those who invested during 2002-2003, when the markets were at rock bottom, saw the markets deliver significant returns over the next 6 years (2003-2008). Here’s a pertinent cliché that emphasizes this point well - in crisis there can be an opportunity.

Interestingly, it may be a good idea to exit out of assets that have done reasonably well in the past year. Often when assets have given returns in excess of 50 percent in a year, in all probability, the asset class might not deliver the desired returns in the coming year. This may not hold true for equities.

However, looking at the past 15 years, the preferred time to invest in equities is when the industrial production growth rate is low; while, the preferred time to exit equities is when the fiscal deficit is low. Equities also do well as an asset class in years following when their Price Earning(PE) ratio is between 12 to 18 times. If the price-earnings rise higher than 18 times, returns from equities may not be high in the subsequent years. But if the price-earnings multiple is anywhere close to 12 times, it’s a buying opportunity that investors should consider.

Evaluating real estate

In real estate, look at the difference between mortgage rate and rental yield. If there is a difference of less than 5 percent, then real estate may be an attractive proposition. If the difference is above 7 percent, then real estate tends to become unattractive.

Understanding international funds

International funds may tend to do well when inflation and the Current Account Deficit (CAD) are high. In the year 2009, inflation and the Current Account Deficit (CAD) had risen. When inflation and CAD rises, it is relatively a good time to invest in international funds, and vice versa. Nobody at that point of time was willing to invest in international funds since they had significantly under-performed.

A look at when gold funds do well

Gold funds tend to perform well when inflation is high. It also tends to do well when the difference between international gold prices on Brent crude oil price is below 10 percent. On other occasions, when every asset class is doing well, it is a good time to invest in gold.

Grasping the intricacies of debt funds

Debt does well when the one-year bank Fixed Deposit rate is higher than inflation. One has to look at both the wholesale and consumer price indices to arrive at the attractiveness of debt. Look at whether the one-year bank fixed deposit rate is higher than the Wholesale Price Index and also the Consumer price Index. The sum total of both the above ratios should be equal to or more than two for debt to become attractive. If the sum is below two, then fixed income becomes unattractive.

How these guiding principles can serve you

These thumb rules could have helped investors in the past such as investors could have avoided technology funds in 2000. During 1997-2000, all technology stocks gave 200% return. Because of the past high returns, one could have stayed away from such funds.

Investors could have invested in equity funds in 2002. Over the past 6-7 years, return on equity was 0%. This was an indicator that equity could offer potential going forward.

Again, investors could have avoided investing in infrastructure funds in 2007. Returns over the past year of all infrastructure funds were 70-80% and over 2 years, 100-130% returns. These high returns were the indicator to stay away from this sector.

Post the Lehman crisis, investors could have looked at equity funds in Oct 2008. The stock market had given a -40% return in the past year, and was the first sign that equity had potential to deliver returns going forward.

Income funds had become a big no-no in June 2013. The year before that income funds had delivered reasonable returns in the past year, an indicator that debt funds had become unattractive.

Right now, income funds are giving reasonable returns, while equities are now beginning to offer some good opportunities. Equity valuations are at around 16 times forward earnings. Both these asset classes are showing signs that investors could enter into these assets and stay invested in them for the long-term.