Is an all-debt portfolio a smart option?

By Mohasin Athanikar |  06-08-20 | 
 
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About the Author
Mohasin Athanikar is an Investment Analyst for Morningstar Investment Adviser India.

I have sizeable investment through SIP in two equity funds. Both are showing negative returns for last two years. Should I exit these funds to better performing funds or stay invested?

Debt funds have given better returns than equity in the last 5 years. Debt may give less than equity but at least it is assured. Must equity have a place in every portfolio, or can I switch only to debt?

If I have a debt only portfolio, how can I divide it among various types of funds?

While constructing a portfolio, there are three core objectives on every investor’s mind: protect capital, beat inflation and create wealth.

Few may opt for an all-equity portfolio to achieve their goals, with some even opting for a concentrated portfolio of a dozen stocks. However, an asset allocation (mix of equity & debt) based approach is ideal for portfolio construction, since it aims to strike a balance between stability and growth. The recent sharp swings in the markets have reinforced the importance of diversification across asset classes. In Diversify your portfolio, we look at various aspects.

Equity & Fixed-income asset classes are inherently different in terms of their risk-return profile. Equities have the potential to deliver superior inflation-adjusted returns compared to fixed-income over the long term. They are the most favored asset class for wealth generation over the long term, and should form a part of an investor’s portfolio subject to his/her risk appetite.

When compared with other fixed-rate instruments such as fixed deposits or small savings or bonds, equity is more volatile. The returns are not assured. And there is even the possibility of loss of invested capital. However, over longer time horizons, equities tend to outperform most asset classes with diminishing probability of capital loss.

While equity fulfills the role of wealth creation, fixed-income offers stability to the portfolio. The returns on offer for fixed-income instruments are dependent on factors such as the inflation estimate over the investment horizon, the real returns offered, and the credit, maturity and illiquidity risk premiums.

The asset allocation mix should be a function of the risk appetite of the investor. Longer the investment horizon and greater the risk appetite, higher can be the allocation to equities.

You have put forth the suggestion of opting only for debt. An individual who boasts of an all-debt portfolio would be happy today. Would he be in such a position if a few years down the road there is a secular bull market and his returns are lagging behind?

Let’s look at some annualized returns as on July 30, 2020.

Equity

  • Index: S&P BSE 500 PR Index
  • Return: 7.12% (10 years), 10.69% (15 years)

Debt

  • Index: CCIL All Sovereign TR Index
  • Return: 9.36% (10 years), 8.31% (15 years)

Equity over the past 2 years

  • S&P BSE 500 TRI: -1.84%
  • SIP in S&P BSE 500 TRI: -1.76%
  • SIP in large-cap index S&P BSE 100 TRI: -0.50%
  • SIP in mid-cap index BSE Midcap TRI: -6.04%
  • SIP in small-cap index BSE Small Cap TRI: -10.26%

Debt over the past 2 years

  • SIP in CCIL All Sovereign TR Index: 14.79%

Equities have particularly underperformed over the last few years. But the S&P BSE 500 PR Index has delivered 12.35% annualized over 20 years. That is a very impressive return that beats debt.

So it is necessary to look at returns over long time frames.

Over the past few years, there have been concerns about the economic slowdown which got aggravated due to the COVID-19 lockdown. During the same period, sharp rate cuts and abundant liquidity has resulted in yields falling dramatically particularly at the shorter end of the curve, benefiting fixed-income funds which have delivered wholesome returns.

We believe that Systematic Investment Plans, or SIPs, are the best way to invest in equity over the long term. Please do read The case for SIP for a better perspective.

SIPs are a mode of investment facilitating regular investments, enabling an investor to average the cost of his investments. This benefits investors in falling markets as they would be buying units at cheaper prices. Although markets have seen a sharp bounce-back in the YTD period on the back of a global liquidity-driven rally, domestic equities are still down 7.59% (as of July 30, 2020).

Here are some final thoughts:

  • If you have a long time horizon, it would be wise to remain invested as equities tend to deliver positive inflation-adjusted returns in the long run.
  • No matter how lopsided the returns from one asset class are, it is wise to be diversified across asset-classes.
  • SIP provides consistency, and instills a discipline which will bear much fruit over the long term.
  • Always evaluate the performance of the funds in your portfolio vis-à-vis that of their respective category peers. If a fund has been delivering below-average performance consistently, you may switch to a more consistent one.
  • An all-debt portfolio won’t be free of risk. Like equities, fixed-income funds too are prone to the risk of capital loss, as has been reinforced by the recent market events over the past two years, which saw markdowns in several debt funds following downgrades and defaults of various issuers.

We suggest that you consult your financial adviser before taking any investment decisions.

Registered readers can post their queries by accessing the Ask Morningstar tab. Our team will answer SELECT queries ONLY relating to mutual funds and portfolio planning.

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