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Escalating Gains

Investors need to overcome common human inclinations to take gainful action when markets are down

Of all the things that an investor is asked to do, handling market crashes in a level-headed manner is the most difficult. That's the time when instincts of the human animal and the needs of sensible investing conflict the most. Both the logic and the history of investment markets show that nothing creates future value with greater certainty than investing when prices are down. And yet, nothing comes more automatically to investors to do the opposite.

Mutual fund investors are always told to invest gradually and continuously and preferably through systematic investment plans (SIPs). These plans automatically require the investment of a certain fixed amount every month. While there are many uses for SIPs, the most important is that they are likely to keep you investing even when the markets are down and, this is often not mentioned, they also help reduce the chance of excitedly dumping money into the markets when they are up.

Beyond a simple strategy like SIPs, investors are often recommended another technique that is even more difficult to practice - that of rebalancing. The basic idea is to make sure that the ratio of debt and equity doesn't deviate from a preset level. When one rises because it has done well, then you are supposed to take some money from it and put it into the other. Again, this is an incredibly hard thing to do, because it goes completely against instinct to sell the winners and add the money to what looks like a loser.

While these techniques are simple ones meant for individual investors, there is a very interesting mutual fund that practices an automated way of balancing between equity and debt and has built up a remarkable track record over six years of doing so. This fund is called the FT India Dynamic PE Ratio Fund of Funds and is run by Franklin Templeton. This is a hybrid fund that balances between the two asset types in a completely automated, algorithm-driven manner. The idea is to use the Price-Equity (P-E) ratio of the Nifty index to set the level of equity exposure that the fund should carry. Since the P-E ratio is a basic indicator of whether stocks are underpriced or overpriced, the approach decreases equity exposure as the markets rise up to a more risky level.

This sort of a thing takes a long time to bear fruit, but eventually, it does. Five years ago, when the stock markets were at reasonable levels, the fund had an equity exposure of around 70-80 per cent. As the markets surged, stocks kept getting overpriced and the PE kept rising. Eventually, when the markets peaked in January, 2008, this fund's equity exposure was about 50 per cent. Obviously, during the crash the fund fell less.

However, the interesting part of the story was what happened subsequently. As P-Es collapsed in tandem with stock prices, the algorithmic nature of the fund's asset allocation model ensured that equity exposure was boosted. When the markets turned up decisively, in March this year the fund's equity exposure was around 90 per cent and the fund made huge gains. All in all, this fund has a nearly exceptional combination of falling less when the markets crash and rising more when they climb. The beauty of it is that it's driven in a very simple fashion by a common sense rule. While the fund itself is relatively small and less popular than it deserves to be, it holds an interesting lesson for every investor.