Should You Rebalance Your Mutual Fund Portfolio Amid Expensive Equity Valuations?

January 5, 2022 Mutual Fund

The New Year 2022 has begun on a strong note for the equity market; the S&P BSE Sensex has risen over 1,500 points and currently trading near the 60,000 level. But as we head further into 2022, we are likely to see several economic and financial transitions that could impact the growth of equity market and equity mutual funds.

The equity market generated stellar returns in 2020 and 2021 on the back of lockdown restrictions easing, pick up in most business/industrial activities to pre-COVID levels, growing vaccination drive, and improving consumption trends.

Going forward, a resurgence in COVID-19 cases fuelled by the highly mutated Omicron variant can cause the government to bring back restrictions on the movement of goods and people. This could potentially delay hopes of economic recovery. Meanwhile, rising inflation driven by elevated international energy and commodity prices, and the normalisation of policy by global central banks highlight that investors will have to brace for a hike in interest rates. These factors suggest that the equity market could witness higher volatility in 2022.

[Read: Equity Market Could Turn Volatile in 2022. Should You Invest in Index Funds Now?]

Notably, equity markets are trading at expensive valuations compared to their long term averages due to the high upside seen in the last one and half years. Therefore, any potential headwind can lead to consolidation in the markets.

Table: Key valuation indicators have stayed above long-term averages

(Source: www.bseindia.com)  

Global financial firms such as Goldman Sachs, Morgan Stanley, Nomura, CLSA, and UBS have pointed out the potential risk to returns during the year. They have downgraded Indian equities to equal-weight from the current overweight position, citing expensive valuations and inflationary pressure. That said, they have reiterated that the country’s key fundamentals are positive.

In view of the expensive equity market valuations, potential correction, and muted returns expectation, does it make sense to redeem/book profit in equity mutual funds and shift to debt mutual funds?

Let’s find out…

Striking the right asset allocation mix is the best way to mitigate the impact of uncertain and volatile market. This involves investing across equity, debt, and gold, etc. based on your risk profile, financial goals, and investment horizon.

As a result, if a particular asset class performs poorly in a year, other asset classes may do well. Thus, diversification across asset classes protects your investment from the downside and concentration risks that could emanate from the portfolio’s exposure to only one asset class. This, in turn, can potentially enhance the returns of your investment portfolio.

However, the market conditions are dynamic in nature and your financial needs can also undergo changes over the tenure of investment. This is why it is important to keep track of your goals and review and/or rebalance your investment portfolio periodically.

In the current market environment where equity as an asset class has outperformed and is trading in an expensive zone, it makes sense to rebalance your equity mutual fund portfolio in favour of debt mutual fund in following scenarios:

1) Your equity mutual fund exposure has deviated sharply from its original allocation

Due to the sharp rally in the equity market in the last 18-20 months, it is likely that the overall weight of equity in your mutual fund portfolio has risen from your intended asset allocation strategy. For instance, let us assume that you started your investment with a respective allocation of 70%, 20%, and 10% in equity mutual fund, debt mutual fund, and gold. Now amid the swift run up in equities, the proportion of equity mutual fund investment in your overall portfolio would have increased to 80% or beyond. Meanwhile, the proportion of debt mutual fund and gold in your portfolio would have simultaneously reduced.

If the equity market corrects or witnesses high volatility going ahead, your portfolio could witness higher drawdown and attract undue risk. In view of this, booking some profit in equity mutual fund and shifting it to debt mutual fund and/or gold can mitigate the impact of any potential high volatility on your portfolio. You can consider gradually shifting allocation to debt mutual fund from equity mutual fund by opting for Systematic Transfer Plan (STP).

2) Your risk profile has changed

Say you started investing in equity mutual fund buoyed by optimism, but now you are wary of any potential drawdown and high volatility. Besides, your risk profile can undergo changes due to various factors such as changes in income, or if you have new financial goals, etc.

While allocation to equity and debt mutual funds has to be done as per your risk profile and financial goals, it is necessary that you rebalance your portfolio in line with change in circumstances. If you are an investor with low to moderate risk profile or if changes in your financial goals warrant following a conservative investment approach, rebalance your portfolio by increasing allocation to less risky categories such as debt mutual fund. This will help you to reduce anxiety related to market volatility and you can comfortably achieve your goals.

3) Your goal is nearing

Equity mutual funds are a potent tool for long term wealth creation, while debt mutual funds are suitable for short term goals and to stabilise your portfolio. So unless you have an investment horizon of at least 3-5 years or more, you should avoid investing in equity mutual funds. If the financial goal for which you have invested is less than 3-5 years away, gradually shift allocation to relatively stable and less risky avenues such as debt mutual fund. By doing so, you will be able to safeguard your corpus from any steep market fall when you want to exit your investment.

But remember that just like equity mutual funds, debt mutual funds are not risk-free and may be prone to volatility depending on interest changes, credit environment, and liquidity conditions. So ensure that you select the best (and most suitable) debt schemes based on your risk profile and investment horizon.

To conclude

If you have a long term investment horizon and a high risk profile, then it makes sense to continue with your equity mutual fund investment. But ensure that you review the performance of your portfolio periodically (at least once a year) to see if it is well placed to achieve your goals. When you review the portfolio, check whether there is a need to weed out the underperforming schemes and replace it with a more suitable alternative. In addition, check if rebalancing the portfolio from equity to debt or vice versa is necessary to align with your personal asset allocation plan. Lastly, avoid investing in too many schemes because it can make the important task of reviewing and rebalancing your portfolio difficult.

This article first appeared on PersonalFN here