Over the last 10 years, both Equity and bond markets have delivered decent returns. In addition, the combination of both asset classes in the portfolio provided good diversification due to relatively low correlation. A simple 60/40 portfolio (60% Equity and 40% debt) was sufficient to generate attractive returns with low volatility.
However, recent strong monetary expansions, rising commodity prices and disruptions in global supply chains, investors are now faced with the challenge of rebalancing their portfolios to account for increased inflation risk and uncertainty.
Historical data shows that periods of high inflation and elevated inflation expectations have a major impact on capital markets. A comprehensive study done globally clearly shows traditional investments perform poorly in inflationary phases, and Indian markets too are not immune to the same which is evident from the analysis given below:
| Since Jan 2000 | ||
| Average monthly returns | ||
| Interest rate regime | ICICI Pru Long-term bond Fund | NIFTY |
| Less than < 7.5% | 0.71% | 1.94% |
| Greater than > 7.5% | 0.63% | 0.34% |
Source: Bloomberg, Avendus proprietary research
The relative weak performance of traditional assets is unfavourable to the portfolio in inflationary phases. Further, periods of adverse shifts to so-called 60/40 diversification caused due to global economic shocks leads to poor diversification. The following table shows the performance of equities and bonds during uncertain times with both performing relatively poor and not able to compensate for losses on other asset classes, which effectively leads to poor risk adjusted returns.
| Equity drawdown Period | NIFTY | ICICI Pru Long-term bond Fund | 60/40 portfolio |
| Jan 08-Nov 08 | -55.1% | 8.9% | -29.5% |
| Jun 13-Aug 13 | -8.6% | -9.4% | -8.9% |
| Mar 15-Feb 16 | -21.5% | 2.1% | -12.0% |
| Jan 22-Jun 22 | -9.1% | -2.7% | -6.5% |
| Average returns | -23.6% | -0.2% | -14.2% |
Source: Bloomberg, Avendus proprietary research
The fact that most portfolios are long GDP and/or benefit from low or falling inflation rates whereas reverse scenario poses great threat to portfolio returns as seen above in different time periods. We, at Avendus Capital believe that to generate steady future returns it is necessary to look at alternative investments such as systematic ruled based strategies which provide required diversification, low to zero correlations and help generate superior risk-adjusted returns. There are multiple such systematic strategies prevalent in India and globally, however we will focus on two relevant strategies as given below
- Rule based trend following strategy: relies on capturing underlying moves in either direction, with the holding period varying between few seconds to few months. This strategy involves taking long and short directional bet on instruments.
- Equity market-neutral strategy: Combination of a long and short portfolio, having marginal to zero directional exposure to the market, with the expectation to generate returns irrespective of the market conditions. The long and short portfolios are typically segregated based on one or more factors with input data used for generating such sub-strategies having sources like company fundamentals, price etc.
To demonstrate the concrete advantages of allocating to systematic strategies, the table below illustrates that with an addition of 20% capital to ruled based systematic strategies, portfolio returns could increase by 1.5-2% p.a. and bring the portfolio volatility down from 10.5% to 9.1% effectively leading to an increased Sharpe ratio of 1.4 from 1.1. More importantly the max drawdown comes down from 16.8% to 10.5%, thus generating much superior risk-adjusted returns.
| Since Jan’2012 | ||
| 60/40 portfolio | Mix of 60/40 (80%) + 20% Systematic strategies (15% Trend following +5% Equity Market Neutral) | |
| Returns (Annualised) | 11.6% | 13.2% |
| Volatility (Annualised) | 10.5% | 9.1% |
| Sharpe Ratio | 1.10 | 1.44 |
| Max. Drawdown | -16.8% | -10.5% |
Source: Bloomberg, Avendus proprietary research
Further, 20% allocation to systematic strategies plays a stabilising role during sharp market declines as shown below. In comparison to 60/40 portfolio, a diversified portfolio reduces losses quite substantially from -10.9% to -6.8%.
| Since Jan’2012 | ||||||
| Equity drawdown period | NIFTY Index | Long term debt fund | Trend Following strategy | Equity Market Neutral | 60/40 portfolio | Mix of 60/40 (80%) + 20% Systematic (15% Trend following +5% Equity Market Neutral) |
| Jan 20-Mar 20 | -29.3% | 3.7% | 21.6% | 10.0% | -16.1% | -9.1% |
| Jun 13-Aug 13 | -8.6% | -9.4% | 5.9% | -0.8% | -8.9% | -6.3% |
| Mar 15-Feb 16 | -21.5% | 2.1% | 7.0% | 36.4% | -12.0% | -6.8% |
| Jan 22-Jun 22 | -9.1% | -2.7% | -1.4% | 8.2% | -6.5% | -5.0% |
| Average returns | -17.1% | -1.5% | 7.4% | 15.0% | -10.9% | -6.8% |
Source: Bloomberg, Avendus proprietary research
The changing tide in the capital markets exposes the weaknesses of traditional portfolios that have so far been primarily geared to long GDP and/or low or falling inflation rates. Investors looking to future-proof their portfolios can look at diversifying to systematic strategies. Click here to know more about the strategies being offered by Avendus Capital.
These strategies will not only hedge inflation risks but also help mitigate the impact of low yields on expected returns. As a result, they act as excellent alternatives of diversification and also “risk mitigators” making them a valuable addition to traditional portfolios.
