The Motilal Oswal ETF Conclave 2012 breaks down how we can build portfolios using simple and inexpensive products such as ETFs and index funds. Effectively an advisor can add value in many ways because there are three sources of return in the market.
One is market return which we call beta, the second is market timing depending on when you buy and sell and the third is active stock selection which an active manager brings to the table.
To focus on this theme, Nitin Rakesh, the managing director and chief executive officer of Motilal Oswal discusses it with his panel guests - AMC James Norris, managing director, Vanguard International, Frank Satterthwaite, Vanguard Strategy and Finance and Anup Bagchi, managing director and chief executive officer, ICICI Securities.
Below is an edited transcript of their interview on CNBC-TV18. Watch the accompanying videos for more.
Q: What's the best way for an advisor to do an asset allocation type portfolio? Does asset allocation actually add value?
Norris: For us it’s never a question of indexing or active, number one. We generally talk about an idea of core satellite where indexing is the core of your portfolio and active is more of the satellites around your portfolio. We have done a lot of our own research in that area which really does show it’s the most efficient place to be on the frontier is actually a combination of indexing and active. The challenge is, if you are active, is an active it doesn’t work.
You will actually end up on a much more inferior place on that efficient frontier. The key is when you are buying active, would be beta buy active. I think both of them go together. There has been so much research done that the value of asset allocation in driving the performance of portfolios versus the potential incremental value that you can get from adding some kind of selection risk on top of that, it’s pretty incremental.
If you are fortunate or maybe incredibly skilled at it, there could be periods of time where you actually will add significant value on top of it but you just have to recognise that inevitably there are going to be times when you don’t. I just often feel like part of the problem is that clients have a very unfortunate way of forgetting the value that you provided in periods one, two and three but they remember the value that you didn’t provide in period four. That’s also part of the challenge - clients just don’t often recognize the whole period.
Q: One of the foundations of an asset allocation driven investment approach is the fact that you need to have assets that have lower correlations stocks, bonds, cash, commodities, currency etc. The general perception is that correlations don’t stay; everything tends to fall together, especially, when volatility goes on. Does the asset allocation actually work in periods of high volatility?
Satterthwaite: The studies that we have done and the studies pretty much cover the globe is, is that in short periods of time, it may actually appear like all the correlations are going to one, so that everything is moving in the same direction. But, really when you talk about asset allocation you have to look at over a longer period of time - 3-5-7-10 years.
I think the part of the discussion where the advisor is adding alpha is by having a bit of a longer-term view and not necessarily panic when all those correlations go to one and be in a situation that you want to get that benefit through the entire cycle. There are periods where stuff moves together, but over a longer period of time when you look at those correlations, they actually do hold and actually are different.
But fundamentally the stocks, bonds, cash correlations over relatively long periods of time, five years have been pretty consistent throughout the entire world and throughout the ages.
Q: Do we tend to over emphasize or under emphasize on the benefits of something like rebalancing for example. Talk to us about rebalancing a portfolio and how important it is?
Satterthwaite: I really think that is a very important component of the value that an advisor adds. If you have your asset allocation conversation, you have a goal in mind, you have a timeframe that you want to reach your goal, those two together form how much risk you want to take. When you put those two together, its okay I want to save money for retirement.
For example - let’s say Nitin is a young guy; he has got like 35 years to go. We are going to say 35 years that’s going to be a pretty heavy equity allocation and of relatively later bond say 80:20, 80% is equity, 20% is bonds. Let’s say equities are going up, we are going to rebalance into the bonds and that is really important because what you are actually doing is you are selling the asset that’s increasing in value and you are buying the asset that’s decreasing in value and you actually want to sell high and buy low and that’s exactly what rebalancing does.
It also brings you back to the risk profile that you wanted to take because if equities keep going up Nitin is going to have a higher allocation to equities and if equities go down he is going to get hurt. So that’s why rebalancing is really important - quarterly, semi-annually would be our recommendation in terms of when you should be rebalancing.
You don’t have to rebalance everyday. You need the discipline and that is the value of the advisor is having that discipline to say we need to rebalance this portfolio or but wait equities are going great, that’s alright we need to rebalance the portfolio and also when equities are going down you need to be buying. So it’s a really important part of value that an advisor adds is that rebalancing.
Norris: The interesting thing is if you think about it from 1990 to 2000, if you had every year that you rebalanced would it have been worst for your client because equities were consistently doing better than bonds and cash, in which case if you had not rebalanced each year would have been better and better because you would have been more heavily invested in stocks.
But if you had started at 70-30%, by the time you hit the year 2000, you would have been closer to 90-10%. That wasn’t the allocation you intended, but the bad news is all of a sudden 2000 hits and when the equity markets tank, they don’t tank on your 70%, they tank on your 90% and in that just one year where you were not reallocated would have made all the benefits that you gave up for nine years worthwhile. It’s very difficult when equities are going up to have the discipline to sell your winners.
Q: The whole issue about rebalancing really is should you continue to rebalance the portfolio so you buy cheap and sell expensive even though the case for equities is harder at these kinds of interest rates?
Bagchi: But today surpluses are increasing and so you don’t have to rebalance that much. If you have a limited pie then the case for rebalancing becomes tougher.
For the complete discussion watch the accompanying videos for more...