The economy is on an upward path. A stable government at the Centre and several macro-economic indicators - drop in global crude oil prices, lower inflation, stabilization of non-performing loans, reigning in of fiscal deficit - indicate a gradual improvement in the Indian economy. With macro indicators well within control, growth is now imminent over the next 3-5 years. This growth would eventually get reflected in market valuations.
In the recent past, the equity markets have been rising with intermittent downward corrections. But the fact is no market goes up in a straight line. This rally has not seen any correction for a long time.
Given the fact that the earnings did not pick up, the correction seems logical. Even during the bull market spanning 2002 to 2007, there were many corrections throughout. In the current phase, this is just the first correction.
Seize the opportunity
These short-term corrections offer investors an opportunity to enter the market at fair valuations. These swings or volatility are expected to continue because of the impact of global trends (crude prices, interest rate movements, geopolitical issues) on the market. This will continue to provide investors windows of opportunity to enter or increase their equity holdings till the US rate hike is factored in.
This phase does not affect the long-term compelling case for Indian equities with a moderated return expectation. With Sensex trading at one-year forward P/E of 15.9x, which is closer to its historic average, the markets are fairly valued at this point of time. Investors can now invest in equities with a medium to long-term horizon to create reasonable wealth.
Even debt markets are poised to do well, as the economic indicators such as inflation and current account deficit have improved reasonably and interest rates are likely to decline over the course of the year.
While the Reserve Bank of India has announced two interest rate cuts in quick successions before the budget, there is an expectation of further rate cuts over the course of the year.
Think long term
In such a scenario, the approach of investors should be to follow the asset allocation principle for their portfolio depending on their risk profile. It is under this principle that an investor was expected to remain invested even in 2013 when there was tremendous pessimism in the equity market as well as now when there is the correction in the bourses.
This is a good long-term strategy and helps to avoid the tendency to redeem at market bottoms and invest at market tops.
As equity is volatile in the short-term, investors can get impatient with the stock market on seeing their portfolios in the red, particularly those who have recently entered the stock market.
But with the equity market expected to do well in the long run, investors should not ignore equity in their investment portfolios. India's structural growth story is conducive to equities delivering good returns in the next three to five years. Along with such good opportunities, however, comes volatility - and the way to reduce such volatility is to invest in balanced funds.
Experience best of both worlds
These funds have a pre-determined allocation towards debt and equity, thus offering the benefit of both worlds - growth of equity and the relative stability of debt. The debt-equity exposure in such funds is rebalanced, depending on the movement in stock market valuations and expectations of interest rate cuts in the case of debt investments.
Within balanced funds there is a more conservative category called balanced advantage funds. These funds are structured to invest in equities when markets are cheap and book profits when the markets are rising, thus minimising risk and aiming to provide good long-term returns.
These funds have the ability to tilt the portfolio towards the more favourable asset class, using the valuation yardstick such as price-to-book value and comparing it with the mean in order to arrive at the asset allocation break-up.
For investors, such funds offer the convenience of using the asset allocation tool and then invest in multiple securities based on the allocation arrived at.
Such funds could deliver reasonable risk-adjusted returns by simultaneously reducing risk because of the diversity of debt as well as add the essence of growth because of equities.
Let's see how balanced funds can help to smoothen out volatility. Assume that you have invested entirely in equity, which is now down 10 per cent. The value of your portfolio will be reduced by that percentage.
However, suppose you add 50 per cent of debt assets to your portfolio. Even if the equity portion drops 10 per cent, the debt component will hold steady and the value of your portfolio will fall less compared with the equity markets. The debt portion in a balanced fund provides the necessary cushion to your overall portfolio.
Balanced funds also offer tax efficiency. As most balanced funds have 65 per cent exposure to equity, they are taxed like equity funds. Therefore, if the holding period is greater than a year, the applicable long-term capital-gains tax will be nil.
If the holding period is less, the gains are subject to short-term capital gains. In the dividend option, the dividends paid and received are tax-free (attracting no dividend distribution tax), irrespective of the holding period.
Funds in the balanced category are suitable for first-time investors or investors with a moderate risk profile. They enjoy lower volatility and tax efficiency. Such funds usually tend to do well in different types of market cycles if you hold them for the long term.