When one talks of the highest return giving security- the answer is equities. But on second thoughts the risk factor crops in. You fear the risk associated with equities & rather find yourself contented with the fact that your money grows at 8% p.a. in debt market instead of having a chance of earning exceptionally high returns in equities. But what if you get a product wherein the returns are very near to actual equity returns & the risk associated is much lower. In short what if the product falls in Low Risk-High Return Category?

There we understood that proper asset allocation is imperative for building a strong portfolio. By doing investments through IPS route one can earn better returns by diversifying his/her risk.

Although hybrid funds or balanced funds invest both in stocks and bonds, they aren’t asset allocation funds in the true sense. A hybrid fund usually maintains a fixed allocation in stocks and bonds and doesn’t alter it very frequently. On the other hand, an asset allocation fund has the flexibility to move in and out of stocks and bonds or invest in stocks or bonds only. Thus, its allocation may depend on the fund manager’s belief as to which market is expected to perform better. For instance, if the stock markets are doing well, an asset allocation fund may buy stocks with all the money it has. And if the bond market is in a bullish mode, the fund can sell all the stocks it owns and invest in bonds.

Today’s article is on similar lines. Here I introduce you to an investment philosophy of one of the mutual fund schemes which invests in equities in such a way that while you get the advantage of growth opportunities there is also a lesser impact of market volatility on your investments.

The fund is Franklin Templeton India Dynamic PE Ratio Fund Of Funds (FTDPEF). It is a fund of funds (mutual fund scheme which invests in other existing mutual fund schemes). It invests in Franklin India Bluechip Fund (FIBCF) & Templeton India Income Fund (TIIF). It has an equity allocation that is based on the price-to-earnings (PE) level of a pre-decided index—in this case it is the Nifty.

What is PE level/ PE ratio?

PE ratio of a company—a ratio of its market price to earnings per share, indicates the price you pay to buy a rupee’s worth of earnings in a particular company. If the market believes in a high earning potential of a company it may be willing to pay a high price, hence, the PE would be high. Similar is the case with PE of an index too. A high PE ratio of an index indicates an overall bullish sentiment and vice versa.

So, if the Nifty’s PE ratio is below 12, FT India PE ratio would invest 90-100 per cent of its assets in equities and the rest in bonds. If the PE ratio increases to 12-16, it will reduce its equity allocation to 70-90 per cent. The result of all this will be that the fund will sell equities when markets are rising and, hence, reduce the downside risk. And when the PE is low, the fund would invest in equities to gain from a potential upside. So, while the downside is limited, the gains could also be limited because by selling in a rising market, the fund may not be able to fully capitalize on the further upside, if any.

If the weighted average PE ratio of NSE Nifty falls in the band…… ….then the % allocation to equity fund will be
Upto 12                      90-100
12-16                          70-90
16-20                          50-70
20-24                          30-50
24-28                          10-30
Above 28                  0-10

The Risk Adjusted Return

Risk Adjusted Returns in simple terms measures whether are you getting adequate returns for the risk you are taking? To make an investment decision one normally just looks at the returns, as in higher the returns better the product. But your decision should not be based only on that. You have to consider the risk associated to get the returns.
  
Let me give you an example, suppose we have two Stocks A & B. Stock A gave a return of 20% in the past one year & Stock B return of 25%. As a layman one would immediately go for Stock B. But before making the decision we have to consider the risk associated. So after using a statistical formula, if we are given that risk for Stock A is 2 units & for Stock B is 3 units, then we have to divide the returns with the risk to get the risk adjusted returns & decide accordingly.

Hence, the risk adjusted returns of stock A is 20/2 i.e. 10% & stock B is 25/3 i.e. 8.33%. So we conclude Stock A is better. Though plain returns of stock B are more but after factoring risk associated with the stocks, it is Stock A that scores more!!!!!!!!

So, after comparing this Franklin Templeton India Dynamic PE Ratio Fund Of Funds with other equity funds it has been analyzed that its risk adjusted returns are far better over its peers.

I have just tried to explain the peculiar investment philosophy of this fund (This is not an advertisement or an effort to push this product). There would be other funds in this category too. My aim is to educate you about the investment styles you should follow so that you can take better investment decisions. 

An investment in knowledge pays the best interest.
         -Benjamin Franklin

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This entry was posted on Tuesday, August 11th, 2009 at 1:37 am and is filed under Mukesh Dedhia's published articles. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.