Understanding Asset Classes And Their Returns The Right Way

Most investors today hold multiple asset classes in a portfolio. They also realise that doing this achieves adequate diversification. But most investors do not fully understand the asset classes they hold. This applies to both the way each asset class behaves and the returns they generate. It causes investors to have unrealistic expectations. And this ultimately leads to disappointment for them. Therefore these asset classes and the returns they offer must be understood the right way. Therefore in today's post I am going to talk about each major asset class in detail. I will first talk about the fundamental nature of each asset class. I will then show what level of returns we can expect from each asset class.

Equity

Acts as the engine for long term growth of the portfolio. Equity essentially represents business ownership. Investing in equity is therefore equivalent to owning businesses. In other words the equity component in a portfolio must capture real economic growth of the country where the investor lives. This helps the maintain the purchasing power of money over time. Investing in a diversified equity portfolio exposes the investor to market risk.

Equity exposure must only be considered for goals that are more than 7 years away from falling due. The standard deviation of equity returns over periods upto seven years is very high. This means that expected returns from equity would have a very broad range over such periods. This renders taking equity exposure over anything less than 7 years imprudent. For goals 8 or more years away, not more than 60% of the portfolio must go to equity. The reason I say this can be understood in an earlier article Why 60 And Equity Are An Ideal Match.

An equity portfolio with pure large cap exposure would be enough for most investors to achieve their financial goals. Investors who desire a better risk adjusted return may consider allocating 20% - 50% of their equity portfolios to mid caps. Small caps are extremely dangerous. They are akin to double edged swords. They offer exponential returns when they do well. But they are perfectly capable of destroying wealth when they go through a bear cycle. They therefore should not be considered unless the investor has shown the capability to remain disciplined and unaffected across multiple market cycles. A single Nifty 50 index fund is sufficient for large cap exposure in the portfolio. A single Nifty Next 50 index fund is sufficient for mid cap exposure in the portfolio.

Over the long term, equity as an asset class offers a post tax return of roughly 3-4% above headline inflation. This is true for most countries across the world. In the Indian context, headline inflation averages around 6%. So it would be reasonable to expect 9-10% post tax from equity. I would personally prefer to err on the side of caution and expect no more than 9% from equity over the long term.

Equity offers us a reasonable probability of an inflation beating return over the long term. So that is all we must expect from it. Accepting this fact would give us greater peace of mind. Let’s say we expect 15-20% returns from equity and it generates 9%. This does not mean that equity has failed as an asset class. It only means our return expectations were unrealistic. And this would only lead to us being disappointed. I have discussed equity portfolio construction in detail in an earlier article The Essence Of Equity.

Debt

Debt as an asset class is meant to provide stability and liquidity to a portfolio. The first principle to adhere to when constructing a debt portfolio is to avoid risk. We would naturally be exposed to enough risk through the equity component of our portfolios. Therefore it makes no sense to increase the risk quotient of our portfolios through the debt component. Most debt portfolios for long term goals would comprise of EPF/PPF/NPS and debt mutual funds. It is essential to avoid investing in debt fund categories that carry credit risk and/or interest rate risk. These are the primary forms of risk in debt products.

Liquid funds and money market funds represent options for long term goals. It would be reasonable to expect long term returns of headline inflation + 1% post tax from debt as an asset class. For short term goals we would primarily stick to bank deposits (savings, fixed and recurring). All our deposits must be held with large, scheduled commercial banks. Deposits offered by companies, small finance banks and cooperative societies must be avoided. Peer to peer lending must also be avoided.

These options carry a higher degree of risk in comparison to commercial banks. This is characterised by the fact that these entities offer a higher interest rate in comparison to commercial banks. The higher interest rate offered is meant to compensate investors for the additional risk involved. Those looking to understand debt portfolio construction in detail may have a look at my earlier article Distilling Debt Portfolio Construction.

Gold

Gold held in securitised form (gold mutual funds, ETFs and SGBs) may be considered for an investment portfolio. Gold has broadly offered inflation linked returns over the long term. This represents a return of headline inflation + 1-2% post tax. Therefore gold cannot play the role of a wealth creator in a portfolio. But gold is a safe haven during an economic crisis. Also, gold enjoys a low degree of correlation with asset classes such as equity and debt. This means gold may outperform when equity and debt underperform. We must ensure that our exposure to gold does not exceed 10% of our overall portfolios.

But it must be mentioned that gold is a peculiar asset class. It carries a level of volatility similar to equity. But the returns it offers is akin to that of a debt instrument. So including gold may not always make sense from a risk-reward perspective. Including gold also heightens complexity when managing and rebalancing the portfolio. A detailed understanding of gold as an asset class is offered in my earlier article Going For Gold.

International Equity

It is only when some part of an investor’s consumption is likely to happen overseas should international equity be considered. This is because the core basis of investment is consumption. In other words, the reason we invest for our various goals today is to be able to consume when our goals fall due. A few examples of this fact are laid out in the graphic that follows.

Exposure must not exceed 10% of the value of the equity portfolio. This is because portfolio rebalancing becomes more complex when international exposure is taken. Say an investor holds equity and debt in their portfolio with an asset allocation of 60:40. Also assume their equity component has an 80:20 allocation to a Nifty 50 index fund (Indian) and a S&P 500 INR ETF (US) respectively. Effectively, the amount allocated to the Nifty 50 index fund would be 48 (60 * 80%). And the amount allocated to the S&P ETF would be 12 (60 * 20%).

The investor now needs to ensure that they maintain their equity mix at 80:20 between India and US. This is independent of having to maintain their overall portfolio mix at 60:40. Also international equity creates exchange rate risk in the portfolio. But it does very little to increase returns at the portfolio level. Let me explain.

Indian investors mostly look at American markets for international exposure. Headline inflation in America is currently around 3%. Therefore a realistic post tax assumption from US equity would be around 6%. Now assume 10% of the portfolio is allocated to American markets. The overall incremental return earned on the portfolio in such a case would be just 0.6% (6%*10%). Most of these gains would be eaten away by costs and exchange rate risks. This clearly shows that international equity makes very little sense in most cases.

Real Estate

A traditional favourite among Indian investors. Real estate may make sense if purchased for occupation. But other than that significant exposure to residential real estate makes limited sense. This is especially true if residential property is purchased purely as an investment. Significant real estate investments would severely skew our overall asset allocation. Rental yields in India currently range between 2% and 3.5% of the value of the property. This is lower than the return offered by bank deposits.

Furthermore it is hard to sell real estate for a fair price at short notice. After a sale, we may hesitate to pay the taxes applicable on the capital gains from the sale. Therefore the proceeds are invariably used to purchase or construct another property. This means we rarely get to actually enjoy the gains from our real estate investments.

The Right Way To Put Everything Together

Investors sometimes assess returns from a portfolio with multiple asset classes the wrong way. They just add up returns from each asset class to arrive at the portfolio return. But investors must assess returns on a weighted average basis. This is done by multiplying the weight of each asset class with its return. The resultant figures are then added to arrive at the portfolio return.

Consider a portfolio comprising of the following asset classes. Their weights and post tax returns are also given as follows :

Domestic equity (50% weight, 9% return)

International equity (10% weight, 6% return)

Domestic debt (30% weight, 7% return)

Gold (10% weight, 7% return)

The weighted average return of the portfolio can now be calculated as shown below.

Wrapping Up

Let me be the first to admit that most of the views expressed in this article may seem overly conservative. This is especially true with regard to aspects such as the return expectations and product choices used. The same can be said for the for my reluctance to include small cap and international equity in the portfolio. A considerable number of my clients also say the same during our conversations together. But I have simply presented a realistic explanation of the way each asset class works. And what is realistic is rarely exciting. But having a holistic understanding helps us set the right expectations from each asset class and our portfolios. We would then focus on the thing that really matters. The attainment of our goals and peace with our money. This reduces the likelihood of us being disappointed.