Asset Allocation In A Challenging Environment

Contributed by: Vivek Yadav

IAIP Bangalore hosted a topic that  members considered the need of the hour – Asset Allocation in Challenging Environment presided by Dr. Rajan Govil, the co-founder of Marketnomix.

Dr. Govil began by talking about the key inputs for Asset Allocation i.e an analysis of key economic parameters to estimate expected returns for a final asset allocation.  He also shared his perspective on the Global, and Indian Economies apart from his thoughts on the  state of the global financial system. He expects global growth to slow down in the coming years unless there is a radical change in resource productivity curve, given that, enhanced productivity directly impacts growth alongside labor and capital.

Some of the key issues he focused on during his engaging session:

Lack of Economic growth data availability on a Real-Time Basis

On the subject of asset allocation, he noted that several micro and macro factors influence investment decisions. In the case of a strategic asset allocation, it is advisable to balance one’s portfolio once in a quarter and have time horizon of about 3 years. Since GDP numbers are not available on a real-time basis, one can look for regular indicators like 2 wheeler and/or diesel sales to estimate the level of economic activity.

Impact of cultural on Asset Allocation

He highlighted that specific asset classes such as gold, have sentimental value associated with it in countries like India. He believes that s gold has no intrinsic value and its price is only determined by the demand for it, and that one should be cautious so as not to over invest in gold. Further, gold unlike foreign currency does not typically act as a counter balance for high inflation.

Inflation and its impact on Asset Allocation

Dr. Govil opined that the Central Bank’s mandate to handle inflation, sans unemployment rate, does not have a scientific rationale. He also suggested that there is little evidence whether inflation-targeting countries have done better than non-inflation targeting countries. Further, he shared that it is advisable to not manage inflation and control exchange rates at the same time.

Inflation is best managed when the government does a thorough job of preparing 12-month forecasts on demand and supply of products and services, and, consequently forecasting the rate of inflation. In India, the Central Bank has scope for improving its inflation forecast given that the actual rate has differed considerably from initial estimates. The current fall in the rate of inflation is strongly correlated to the decline in international oil prices amidst many minor India specific factors.

Certain prerequisites for inflation targeting to work include:

  • Sound and responsive Monetary System that quickly passes on decision made by the Central Bank to the end users.
  • Limited / no control on Foreign Currency
  • General public savings to improve our current account balance

Inflation creates both opportunities and challenges. On one hand, investors need investment products with risk-adjusted performance that beat inflation, while on the other, returns from asset management are squeezed in real terms because of inflation and increased costs associated with changes to regulation and compliance.

Further, independent factors, such as asset bubbles or changes in the business cycle, when added to inflation, can create very different outcomes and call for customized approaches. With these aspects in mind, diversification is a critical first step for investors. Further, inflation protection should be incorporated and treated as a core component of portfolio modeling and construction. He urged portfolio managers to build sound strategies that combat these concerns and that are customized to address individual objectives and time horizons.

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