Monday, October 09, 2006

Risk Management: Allocation of funds to equity and debt

I am sure many of you might have wondered how much exposure to equity is safe at any point of time. I am suggesting two methods, one based on weighted average PE Ratio of Nifty or Sensex, and the second based on term of the policy.

Fund Allocation Based on Nifty/Sensex PE Ratio
In this approach, I decide my allocations to equity and debt based on weighted average PE Ratio of Nifty or Sensex. At higher PE Ratio levels, I advise reducing your exposure to equity. Similarly at lower PE Ratio levels increase your exposure to equity. You will be able to find weighted average PE Ratio of Nifty or Sensex at or The reasoning behind this approach is we have lesser exposure to equity when we think the market is expensive. We have more exposure to equity when the market is cheap. The following is the asset allocation I would suggest based on PE Ratios.

PE RatioEquity Exposure %Debt Exposure %
Below 1390 - 1000 - 10
13 - 1670 - 9010 - 30
16 - 2050 - 7030 - 50
20 - 2420 - 5050 - 80
Above 240 - 2080 - 100

Fund Allocation based on the Term to Maturity
This approach is applicable to goal based investing, example planning for children's marriage. In this approach we decide asset allocation ratios based on the term remaining till goal or maturity. The longer the term to maturity in years, the higher the exposure to equity. The idea behind this approach is that we take higher risk when we have more time on our side. We take less risk if the by when we need to funds is less.

Term Left from GoalEquity Exposure %Debt Exposure %
Less than 3 years0 - 2080 - 100
3 - 6 Years20 - 5050 - 80
6 - 10 Years50 - 8020 - 50
More than 10 years80 - 1000 - 20


Vamsi Chikkam said...

Thanks Raj with Few more new advices..

It is really awesome....

-Vamsi Chikkam

the_blue_quill said...

Thankyou for your advice. But can you please explain the basis/logic behind your suggestion of asset allocation based on p/e ratio. It will help us in understanding things in detail.

Raj Gopal Vuppala said...

Price to Earnings Ratio (PE ratio) is the ratio of the stock price of a company to its earnings per share. In other words, it is the price one pays for every rupee of earnings. The higher the PE ratio, the more expensive the stock or market is, because one is paying more for the same level of earnings. The PE ratio of the index is the weighted average PE ratio of the constituent stocks of the index. The strategy is to increase the allocation to equity when markets are down, i.e when PE ratio falls to help you capitalise on the upside potential, and reduces the allocation to equity when markets are high, i.e when PE ratio is high to limit the downside risk.

Franklin Templeton India has a mutual fund which dynamically modifies its allocation to equity and debt based on similar principle. The fund is called Franklin Templeton India PE Ratio Fund of Funds. I am suggesting a similar approach based on PE Ratios for managing your allocation to Equity and Debt for ULIPS.

the_blue_quill said...

Thanks for your reply. I was discuusing ulips with a friend and he suggested me the folllowing. As per him, during february-march when the sensex is around its high, I should transfer all my units from equity to bomd fund. Then in March-April when , after the budget, the sensex starts to climb back, I can reallocate my funds to equity, thereby i will be getting more units at a lesser NAV.
Can you please explain the credibilty/soundness of such a advice.

Raj Gopal Vuppala said...

I don't think there is any merit to his strategy purely based on dates or budget.

Anonymous said...

Suppose i have a particular ulip with 100% in equity. I now wish to change my holding to 70:30 equity:debt. What actually happens with my money? What does it imply when i say that 30 % of my money is in debt? How are the returns calculated when i finally liquidate my fund?

Raj Gopal Vuppala said...

In ULIPS, you have different fund which you can choose to invest your money. There is a NAV(Net Asset Value) associated with each fund.

Let us say you have 1000 Units of Equity Fund. Let us assume todays NAV(Net Asset Value) of equity fund is Rs.45. Your total holdings would equate too

1000 unit of Equity fund = 1000 * Rs.45 = Rs.45,000

Now you wish to move 30% of these to debt fund. 30% of the 1000 units you hold would equate to 300 units.

300 units of Equity fund = 300 * 45 = Rs.13,500. (This is the amount you want to move to debt)

Let us say the NAV of debt fund is Rs.15. You will be able buy 900 units of debt fund with the Rs.13,500 you have.

The following is what your holdings would look like at 70:30 equity/debt.

700 units of Equity fund = 700 * Rs.45 = Rs.31,500
900 units of Debt fund = 900 * Rs.15 = Rs.13,500

The total amount is still Rs.45,000. But now you own units of equity and debt fund.

Let us assume you wish to sell off all your holdings three years from now. At the time of selling, let us assume the NAV of equity fund is Rs.67.50 and that of debt fund is Rs.18.00. Based on NAV of fund your investments in equity fund grew by 50% in three years and your investments in debt fund grew by 20% in three years

700 units of equity fund = 700 * Rs.67.50 = Rs.47,250
900 units of debt fund = 900 * Rs.18.00 = Rs.16,200

The total value of your investments = Rs.47,250 + Rs.16,200 = Rs.63,450. This is the amount you would get back if you sell off your holdings at the end of three years.

Anonymous said...

what is the break up of the upfront deduction done in the premium for the initial years in a ULIP investment.

For e.g, In HDFC the first two years they deduct 25 % flat and invest only the balance 75% amount.
The balance years they invest 99 % of the premium amount.

DataAlp said...

Hi Raj,
I was searching for the average PE ratio of the companies listed in NSE and came across your blog.
Is there a way where one can get the PE ratios (TTE and forward looking) for all the companies listed in the NSE (or BSE) so that one can calculate the PE ratio of the index and decide his debt / equity exposure accordingly?
Thanks in anticipation

Raj Gopal Vuppala said...

I am not sure of a site where you can get forward PE ratio for all the companies.

I visit for checking the PE ratio of the index.


Anonymous said...

Hi Raj,

I was going through your blog and I was really amazed to see your wealth of knowledge. I really appreciate your effort in guiding small investors.

I'm a 27 year old. I had applied for Lic's term insurance plan 2 year back. Since I'm diabetic, Lic rejected my application for term plan and instead they offered endowment plan (plan 14). I accepted it as I had no other option and I needed some coverage.
I'm paying 38k for a coverage of 9 lac, in this policy. Since premium was very huge I couldn't afford more coverage.

Now, I approached Kotak for term insurance and they have agreed, but with extra premium, considering that I'm diabetic.
Their offer is like this,
Coverage Premium
25 lac 19350/-
15lac 14000/-

Now I have following doubts in my mind:
1) Since Kotak is a private company, what is its reliability. What will happen, if the company goes bankrupt? Will my coverage cease to exist in this scenario? Do I have to start looking for another coverage at that situation?
How risky are these private insurance companies?

2) For how much of coverage i need to take from Kotak, 15lac or 25lac?

3) Should I convert my existing endowment policy from Lic as paid up? (Assuming I take 25lac coverage from Kotak)

Please reply me, as I'm totally confused and I need a totally unbiased suggestion from an expert like you.


Raj Gopal Vuppala said...

Dear Praveen,

First, I will advise you to use a Human Life Value calculator to determine how much insurance cover you need. Please use the below link to know about calculating HLV, and it also has the calculator to determine your specific needs.

Once you determine how much insurance you need, please take the term insurance offered by Kotak. If cover from a single term policy is not adequate, then I would advise you to go for multiple policies.

Since you primary objective is insurance and not investments, I would advise you to make your policy paidup. But before making the policy paidup, please ensure you have adequate insurance cover. If you do not have adequate insurance cover, then continue the LIC policy for cover of 9 Lakhs.

Regarding insurance companies going bust, I am not fully aware of the implications. Hence I am not qualified to answer that question as half knowledge can be dangerous. I myself am researching about the implications of insurance companies going bust.


Ratnakar said...

Hi Raj,
I have HDFC Young Star ULIP taken last year Nov 2007 when the market was ~16K for an annual premium 24000.00 and choosen for annual premium mode. Now this month I have to pay next year premium. My question is 1)In ULIP paying annual premium is good or monthly. which mode is better to opt? 2)Should I go for paying Annual premium this time for the next year premium as the market is very low where i will get more units? Please suggest.

Raj Gopal Vuppala said...

Dear Ratnakar,

In ULIP's monthly option makes the most sense. So always go for the monthly premium option rather than yearly.

For your second question, my advise is to not try timing the market. So I would again suggest montly premium option even this year.


Anonymous said...

what are the top performing funds especially ullips? and where icici pru stands in the segment?

Raj Gopal Vuppala said...

You can compare the performance of ULIP's at the website

There should be a link for ULIP Monitor. Please use the link to check where ICICI Pru ULIPS stands.