Dynamic Asset Allocation Mutual Funds: Yield Gap vs. P/E Ratio

While investing periodically for long-term goals, an investor should be aware of two factors:

  • The power of compounding oh-hum, boring!  I am sure most people reading this are tired of see how a small investment grows to an unimaginably large value … after several decades!
  • Volatility Most of us must invest in volatile instruments like equity in order to ensure our returns (post-tax!) are higher than inflation (also volatile!).  The trouble with volatility is that it can destroy the fruit of compounding.

 Therefore, understanding volatility, and containing using intelligent measures  it is crucial for long-term goals.

In this post, we will discuss a technique known as dynamic asset allocation and discuss two ways of doing this.

This post is inspired by the new fund offer from DSP Black Rock: Dynamic Asset Allocation mutual fund using the Yield Gap method.

 Note: This is not an advertisement for any mutual fund. It is presented only as evidence of the author’s ongoing efforts to educate himself.

First, let us first list the steps to be adopted by every long-term investor.

  1. Invest as much as possible
  2. Invest as often as possible
  3. Understand the importance of volatility and how to contain it –Keep calm and carry on!
  4. Diversify across asset classes: invest in equity but do not forget debt
  5. Diversify within an asset class: spread your equity investments across market caps and geographies
  6. Periodically modify asset allocation: Changing equity and debt percentages to minimize volatility – the subject of this post.
  7. Taxation: Never forget taxation
  8. Quit while ahead: When you near your goal, get out of volatile instrument when the going is good.

 If the first three tasks are in motion, the rest will follow.

Now, let us discuss about periodic changes to asset allocation.

I. Rebalancing a portfolio each year is the simplest way to do this. If we start with a 60:40 equity:debt allocation and find that it is 65:35 after an year, you could rebalance  it back to 60:40. This way you have preserved the gains by shifting it from a more risky asset. For this to be successful, one must have the maturity to invest more in equity when it underperforms.

I have dealt with rebalancing techniques in reasonable detail.  To know more, check out:

II.  Permanent portfolio A delightfully simple way to contain volatility is the Permanent portfolio method. Invest in Stocks, Bonds, Gold and Cash in equity proportion (25%) and rebalance each years. I have not checked returns after taxes but the portfolio has a remarkable downside protection: The Permanent Portfolio: A Fascinating Low-Volatility Option For The Long Term Indian Investor?

III. The P/E model

The P/E ratio or the price/earnings ratio is simply the share price divided by earnings per share in the last 12 months. Although variations of this definition exist, this should suffice for our purposes.

If the P/E ratio is high, the share is ‘priced’ higher than the value received from it. That is earning profit from the share is an expensive task.

If the P/E ratio is low, the share is ‘priced’ lower than the value received from it.  That is it is cheaper to earn a profit from the share.

There is much more to it.  You will soon recognise that I am cherry picking explanations that suit me!

For a single share, it is difficult to ascertain what a high or low P/E is, as there are many other factors at work.

However, the P/E ratio of an index, “the total price of the index divided by its total earnings”, has been used as a reference to buy low and sell high.

That is, buy when the P/E is low and sell when it is high. The logic behind is rather easy to understand.

The P/E ratio is high (overpriced) when the index stocks are priced higher than what they are worth (higher earnings higher worth). Therefore, decrease equity exposure since one can expect prices to fall.

Similarly the P/E ratio is low (underpriced) when the index stocks are priced lower than their worth. Therefore, increase equity exposure since once expect prices to increase.

The advantage of this strategy becomes clear when historical Nifty data is plotted along with it P/E ratio (blue curve; right axis)

nifty-1

 

Data Source: Nifty and Nifty P/E

The green rectangle is the ‘buy-band’ when one should increase equity exposure to maximise profit and the red rectangle the ‘sell-band’ when one should decrease equity exposure to minimise loss.

It should be clear enough that this strategy minimise volatility and preserves the fruit of compounding.

Instead of waiting for the P/E to hit the green or red rectangles to change equity exposure, what if the asset allocation is modified more dynamically?

That is what the FT India Dynamic PE Ratio Fund of Funds does!

This is a fund of fund that invests in Franklin India Bluechip Fund (equity component) and Templeton India Income Fund (debt component - G-Secs, PSU Bonds and Corporate debt).

Each month it adjusts its asset allocation in the following way

FT India Dynamic PE Ratio Fund of Funds

Source: Fund Brochure

Here is an example of this strategy at work

FT India Dynamic PE Ratio Fund of Funds allocation

Source: Fund Brochure

IV Yield Gap Model

In the P/E model, the value of stocks are evaluated with their price to earnings ratio. Instead of doing this, what if the price of the equity index is evaluated with respect to the debt index?

That sound reasonable does it not?  Which brings us (finally!) the yield gap model.

For simplicity I will use the definition used for DSP BlackRocks Dynamic Asset Allocation fund

Yield gap = (10 year Govt. Securities yield) X (P/E Nifty index ratio)

The 10-year G-sec yield can simply be thought of as a measure of debt interest rate movement. Again an oversimplification, but should do for our purposes.

When the G-sec yield is high, or when interest rates increase, the corresponding bond prices will become low.  This is because, a bond will have to adjusted to match prevailing interest rates.  Therefore, if rates increase, the bond prices will have to be lowered to match the current rate if they are sold.  Read more about this here

Therefore, higher G-sec yield implies bond prices are cheap and interest rates are high. A good time to invest in debt.

A higher P/E index ratio implies a good time to sell equity.

A lower G-sec yield implies a good time to get out of debt. A lower P/E index ratio implies a good time to buy equity.

Combine the two by taking their product, you have the yield gap.

As general thumb rule,

Yield gap < 1:  low P/E, low G-sec yield.  Shift from debt to equity

Yield gap > 1:  high P/E, high G-sec yield.  Shift from equity to debt

The NFO from DSP BlackRock proposes to invest in a set of equity funds and debt fund from DSPBR with an asset allocation governed by the yield gap

DSP BlackRock Dynamic Asset Allocation Fund Scheme Document

Source: Scheme Document

When there is not much of a difference in yield between 10-year and 1-year G-secs, the scheme will use the 1-year G-sec yield for calculating yield gap.

Which is better ? Dynamic asset allocation using the P/E model or the yield gap model?

Unsurprisingly DSPBR proclaims the superiority of the yield-gap model in its NFO presentation.

DSP BlackRock Dynamic Asset Allocation Fund

Notice how the low volatility of the yield gap curve compared to the P/E curve surrounding the 2008 market crash. While this requires further investigation, the following curve that I put together is reasonably instructive.

Dynamic asset allocation mutual funds

Data Source: Nifty P/E, 10Y G-sec yield  

Nifty P/E ratio (blue curve, left axis)  is plotted along the Yield Gap (red curve; right axis). The 10% equity allocation limit is marked as buy for the PE and Yield Gap fund-of-fund strategies mentioned above.  Similarly, the 90% equity allocation limit is marked as sell. Download link of excel file containing Nifty PE, 10 year G-sec, and yield gap data is given below.

Just by observing both curves one notices that the YG curve is less volatile than the PE curve.

Notice that the YG model recommends a sell (on equity) much before the PE model. Similarly, it also recommends a buy earlier than the PE model.

Therefore, we can expect a portfolio which dynamically changes asset allocation as per the YG model to be less volatile than the PG model.  This appears to corroborate with chart presented by DSPBR.

An early sell call is good for preserving compounding. How about an early buy call? This could mean that we buy before the bottom most-point of a crash. Perhaps this will affect gains, but personally, I like the YG model better.

Note 1:  As of 27th Jan. 2014, The Nifty P/E is 17.85. The 10 year G-sec yield is 8.770%. The yield gap therefore is 1.57.

Note 2: There is a 78% correlation between P/E and YG. Therefore, using the P/E model is certainly not a terrible idea. The YG model can be taught of as a refinement to the P/E model. After all YG depends on the P/E!

Note 3:  A Fund of funds is taxed like a debt fund.  Their expense ratios are usually high.

Note 4:  The PE model fund of funds from Franklin Templeton has not beat the Sensex since inception. If you are young and if your goals are far away should you not be investing more aggressively?

What do you think? Do you agree? Will you consider investing in such dynamic asset allocation mutual funds?

 Download the 10-year G-sec, Nifty P/E and Yield Gap  file.

CNX 500 P/E and YG calculated with it as request by Soma in the comments section. Let me know if you need the data file for this.

CNX

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55 thoughts on “Dynamic Asset Allocation Mutual Funds: Yield Gap vs. P/E Ratio

  1. Soma Sekhara Sharma

    Sir,

    As usally like earlier posts, it is an amazing article, but comes up with an innovative concept "Yield Gap" which will give us about the future of markets and our investments in mutual funds with a great strategy.

    Could you plot a chart with CNX 500 P/E with Yield Gap? I think that gonna give us good idea than comparing with Nifty P/E ratio. CNX 500 P/E Data is available on NSE Website.

    Reply
  2. Soma Sekhara Sharma

    Sir,

    As usally like earlier posts, it is an amazing article, but comes up with an innovative concept "Yield Gap" which will give us about the future of markets and our investments in mutual funds with a great strategy.

    Could you plot a chart with CNX 500 P/E with Yield Gap? I think that gonna give us good idea than comparing with Nifty P/E ratio. CNX 500 P/E Data is available on NSE Website.

    Reply
  3. bharat shah

    this post attracted me more , as it mentioned ' FT India Dynamic PE Ratio Fund of Funds ' in which i invested some a/m probably due to its asset allocation based on p/e in early days of my mf investment 4 yrs ago, latter i left it in short period of 1 yr or so, ,but your post stimulated me to recheck its performance, and found that fund was probably more worth than any equity fund i bought. however i feel that your - Note 4: The PE model fund of funds from Franklin Templeton has not beat the Sensex since inception- may have some error , as i found , it delivered @14.63% cagr v/s sensex fund's 12.66% and fibc's 16.26% during 01-1-2004 to 27-01-2014. even in period of volatility since 08-01-2008 to 27-01-2014 ,it delivered 6.43% cgar v/s sensx fund's mere 0.17%. yield gap modeled mf may even perform better as you mentioned. thank you for bringing the concept in notice with so much details.

    Reply
    1. pattu

      Thanks for sharing these numbers. Please check the numbers available at FT site (link found above). Those numbers give you different story.

      Reply
  4. bharat shah

    this post attracted me more , as it mentioned ' FT India Dynamic PE Ratio Fund of Funds ' in which i invested some a/m probably due to its asset allocation based on p/e in early days of my mf investment 4 yrs ago, latter i left it in short period of 1 yr or so, ,but your post stimulated me to recheck its performance, and found that fund was probably more worth than any equity fund i bought. however i feel that your - Note 4: The PE model fund of funds from Franklin Templeton has not beat the Sensex since inception- may have some error , as i found , it delivered @14.63% cagr v/s sensex fund's 12.66% and fibc's 16.26% during 01-1-2004 to 27-01-2014. even in period of volatility since 08-01-2008 to 27-01-2014 ,it delivered 6.43% cgar v/s sensx fund's mere 0.17%. yield gap modeled mf may even perform better as you mentioned. thank you for bringing the concept in notice with so much details.

    Reply
    1. pattu

      Thanks for sharing these numbers. Please check the numbers available at FT site (link found above). Those numbers give you different story.

      Reply
  5. Viren Phansalkar

    Hello Pattu,

    As for your question, no I would not invest in this auto-asset-adjustment funds.... the reason would be the expense ratio offcourse (since it is fund of fund). And the other reason is, I thought this fund is little complex in nature... Instead, I could choose pure equity funds in initial years and then I could switch to debt funds or liquid funds at later stage of my life.... . These are just my thoughts....

    Thanks,
    Viren Phansalkar
    http://www.iamnospecial.blogspot.com

    Reply
    1. pattu

      Thank Viren. You are right about the expense ratio. There is also tax to consider. Such fofs can be too conservative sometimes and young people should take aggressive stands.

      Reply
  6. Viren Phansalkar

    Hello Pattu,

    As for your question, no I would not invest in this auto-asset-adjustment funds.... the reason would be the expense ratio offcourse (since it is fund of fund). And the other reason is, I thought this fund is little complex in nature... Instead, I could choose pure equity funds in initial years and then I could switch to debt funds or liquid funds at later stage of my life.... . These are just my thoughts....

    Thanks,
    Viren Phansalkar
    http://www.iamnospecial.blogspot.com

    Reply
    1. pattu

      Thank Viren. You are right about the expense ratio. There is also tax to consider. Such fofs can be too conservative sometimes and young people should take aggressive stands.

      Reply
  7. bharat shah

    further i like to know what you think to follow this strategy of dynamic asset allocation with our selected diversified equity mf /s (max. two) and liquid debt/s (max. two) on our own. that may be a little tax efficient and a little expense efficient. how is it comparable to simple asset location strategy?

    Reply
    1. pattu

      Yes I think it is better to do this on our own keeping taxation into mind. The simple PE model using the buy band and sell band is good enough.

      Reply
  8. bharat shah

    further i like to know what you think to follow this strategy of dynamic asset allocation with our selected diversified equity mf /s (max. two) and liquid debt/s (max. two) on our own. that may be a little tax efficient and a little expense efficient. how is it comparable to simple asset location strategy?

    Reply
    1. pattu

      Yes I think it is better to do this on our own keeping taxation into mind. The simple PE model using the buy band and sell band is good enough.

      Reply
  9. Manoj Agrawal

    Dear Sir,

    PE ratio allocation of FT PE Ratio fund in the year Dec 2007 should 10% however they have posted loss of around 25% in 2008 this means they have not followed the asset allocation as per rules defined by the fund and as a result the while comparing the simulated YG fund performance with PE fund performance, YG Fund shows a superior result.
    Further, can you let me know from where i can get daily bond yield. so that i can keep the workbook prepared by you updated and for asset allocation.

    Reply
    1. pattu

      Dear Manoj, Thanks for your views. DSPBRs study is independent of the FT fund. In any case your point is worth independent consideration.

      Reg. bond yield please see the 'source' links in the post.

      Reply
  10. Manoj Agrawal

    Dear Sir,

    PE ratio allocation of FT PE Ratio fund in the year Dec 2007 should 10% however they have posted loss of around 25% in 2008 this means they have not followed the asset allocation as per rules defined by the fund and as a result the while comparing the simulated YG fund performance with PE fund performance, YG Fund shows a superior result.
    Further, can you let me know from where i can get daily bond yield. so that i can keep the workbook prepared by you updated and for asset allocation.

    Reply
    1. pattu

      Dear Manoj, Thanks for your views. DSPBRs study is independent of the FT fund. In any case your point is worth independent consideration.

      Reg. bond yield please see the 'source' links in the post.

      Reply
  11. bharat shah

    one more information i came across in their presentation brochure for the fund that 'If the difference between the Yield Gap ratio and the Modified Yield Gap ratio is less than 0.05, which
    is an indicator of a flat yield curve, then allocation bands based on a moderate version of the Yield Gap, called the Modified Yield Gap, will be applied.' modified yield gap refers the 1 yr bond.now as on date the difference seems less than 0.05 , so for the fund and the its table , the fund will allot 10%, whereas per yield gap table , it is 40%. what do you think about that?

    Reply
    1. pattu

      Excellent point. As I mentioned in the post this makes the investing strategy complicated. Will this make the fund take wrong calls? Only time will tell.

      Reply
  12. bharat shah

    one more information i came across in their presentation brochure for the fund that 'If the difference between the Yield Gap ratio and the Modified Yield Gap ratio is less than 0.05, which
    is an indicator of a flat yield curve, then allocation bands based on a moderate version of the Yield Gap, called the Modified Yield Gap, will be applied.' modified yield gap refers the 1 yr bond.now as on date the difference seems less than 0.05 , so for the fund and the its table , the fund will allot 10%, whereas per yield gap table , it is 40%. what do you think about that?

    Reply
    1. pattu

      Excellent point. As I mentioned in the post this makes the investing strategy complicated. Will this make the fund take wrong calls? Only time will tell.

      Reply
  13. Manoj Agrawal

    Dear Pattu,
    DSPBR NFO presentation says that they have used returns DSPBR PE Ratio fund for comparison, however DSPBR does not have any PE Ratio based investing fund. Thus i was wondering as to which data DSPBR has really used to compare. Then i have come across the article in MINT on this which says they have used DSPBR PE Ratio Fund. Link is given below for your ready reference.

    http://www.livemint.com/Money/nCeh4K9nPkjXDUDDuCyvZL/Product-Crack-DSP-BlackRock-Dynamic-Asset-Allocation-Fund.html

    Thanks for bond yield link.

    Regards,
    Manoj Agrawal

    Reply
    1. pattu

      Their NFO presentation does not mention anything about the FT fun. They have made a PE model strategy using their own funds. Please see the link to the presentation in the post. I just checked it. Thanks.

      Reply
  14. Manoj Agrawal

    Dear Pattu,
    DSPBR NFO presentation says that they have used returns DSPBR PE Ratio fund for comparison, however DSPBR does not have any PE Ratio based investing fund. Thus i was wondering as to which data DSPBR has really used to compare. Then i have come across the article in MINT on this which says they have used DSPBR PE Ratio Fund. Link is given below for your ready reference.

    http://www.livemint.com/Money/nCeh4K9nPkjXDUDDuCyvZL/Product-Crack-DSP-BlackRock-Dynamic-Asset-Allocation-Fund.html

    Thanks for bond yield link.

    Regards,
    Manoj Agrawal

    Reply
    1. pattu

      Their NFO presentation does not mention anything about the FT fun. They have made a PE model strategy using their own funds. Please see the link to the presentation in the post. I just checked it. Thanks.

      Reply
  15. Ravi

    Dear pattu, where to get the latest history of 10yr govt bonds. Is there any file that you have developed where we can pull Niftp/e, p/b, div yield and also 10yr govt yield data.

    My view on rebalancing is that we can use them as a combination. Nifty pe>25, dividend yield less than 1, p/b>6 and yield gap>1.7/1.8 should be strong sell. Considering we are doing SIP, when such combination occurs, it is better to stop SIP, wait until nifty declines to a PE of 17 or so (or) taking yield gap where it is <1, then restart SIP and also invest the pending amounts of SIP that were stopped at 25PE. Please provide your view on this

    Reply
    1. pattu

      Ravi, while agree with your sell call, such a strategy will work only when you exit equity in one go and reenter back. For this a SIP is inconvenient. So monthly investing is better as it is less hassle in terms of paperwork. Stopping the SIP vs. stopping the SIP plus book profit.

      For a strong sell signal, I think stop investments + book profits ( at least LTCG) is a better idea.

      I am preparing a downloader for getting all the data. Will post it soon.

      Reply
  16. Ravi

    Dear pattu, where to get the latest history of 10yr govt bonds. Is there any file that you have developed where we can pull Niftp/e, p/b, div yield and also 10yr govt yield data.

    My view on rebalancing is that we can use them as a combination. Nifty pe>25, dividend yield less than 1, p/b>6 and yield gap>1.7/1.8 should be strong sell. Considering we are doing SIP, when such combination occurs, it is better to stop SIP, wait until nifty declines to a PE of 17 or so (or) taking yield gap where it is <1, then restart SIP and also invest the pending amounts of SIP that were stopped at 25PE. Please provide your view on this

    Reply
    1. pattu

      Ravi, while agree with your sell call, such a strategy will work only when you exit equity in one go and reenter back. For this a SIP is inconvenient. So monthly investing is better as it is less hassle in terms of paperwork. Stopping the SIP vs. stopping the SIP plus book profit.

      For a strong sell signal, I think stop investments + book profits ( at least LTCG) is a better idea.

      I am preparing a downloader for getting all the data. Will post it soon.

      Reply
  17. Ravi

    i also think we should have a gadget on our desktop showing all these 4 parameters 🙂 . I am planning to develop 1 for myself. do u think it will help?

    Reply
  18. Ravi

    i also think we should have a gadget on our desktop showing all these 4 parameters 🙂 . I am planning to develop 1 for myself. do u think it will help?

    Reply
  19. Srinivasan Tiru Seshacharya

    One of the first to come in Dynamic Asset Allocation was ING Optimix Dynamic Asset Allocation Fund, followed by Franklin Templeton Dynamic PE Ration FOF, then Reliance Quant Equity Fund, Pramerica had come with PRAMCERICA DYNAMIC Monthly Income Fund ( Debt) and Dynamic Equity Fund with DART technology, now the DSP BR with Yield Gap Model. And now the Motilal Oswal Movi Index...From the point of recommending these funds which I had used at various points of time based in the so called "backtesting" or simulation none of them beat any kind of benchmark leave alone the flagship funds in any category of the same company. I have asked the fund managers as to why these models with whatever algorithms or quantum models they may be using NEVER EVER beat any benchmark whatsoever inspite of waiting patiently for many cycles of investments? No answer? But to be fair the backtestings from the academic discussions look great but not TRANSLATING to significant performance.

    To be fair these funds at the most have beat the MIP funds and marginally beat the so called balanced funds though they are positioned as Equity funds. What could be the reasons??? Models dont work? Dont think so? They must have some validity ...... what are the dynamics in the capital markets in which actively managed funds at least in India outperform these models which try to remove the elements of emotions/sentiments and supposed to perform better?

    Theory is one thing and the conviction that this works seem to be entirely different .....

    Reply
  20. Srinivasan Tiru Seshacharya

    One of the first to come in Dynamic Asset Allocation was ING Optimix Dynamic Asset Allocation Fund, followed by Franklin Templeton Dynamic PE Ration FOF, then Reliance Quant Equity Fund, Pramerica had come with PRAMCERICA DYNAMIC Monthly Income Fund ( Debt) and Dynamic Equity Fund with DART technology, now the DSP BR with Yield Gap Model. And now the Motilal Oswal Movi Index...From the point of recommending these funds which I had used at various points of time based in the so called "backtesting" or simulation none of them beat any kind of benchmark leave alone the flagship funds in any category of the same company. I have asked the fund managers as to why these models with whatever algorithms or quantum models they may be using NEVER EVER beat any benchmark whatsoever inspite of waiting patiently for many cycles of investments? No answer? But to be fair the backtestings from the academic discussions look great but not TRANSLATING to significant performance.

    To be fair these funds at the most have beat the MIP funds and marginally beat the so called balanced funds though they are positioned as Equity funds. What could be the reasons??? Models dont work? Dont think so? They must have some validity ...... what are the dynamics in the capital markets in which actively managed funds at least in India outperform these models which try to remove the elements of emotions/sentiments and supposed to perform better?

    Theory is one thing and the conviction that this works seem to be entirely different .....

    Reply
  21. R Parikh

    Surprising to see that none of these have beaten the Equity indices - but are they supposed to? further by what margin have they under performed? Also is the underperformance due to expense ratios? or what else could be the reason? Would be interesting to analyse..

    Reply
    1. pattu

      They are not supposed to beat equity indices. They will not work in bull markets! Underperformance is only because of the investing strategy. They don't have enough equity exposure, when they should.

      Reply
  22. R Parikh

    Surprising to see that none of these have beaten the Equity indices - but are they supposed to? further by what margin have they under performed? Also is the underperformance due to expense ratios? or what else could be the reason? Would be interesting to analyse..

    Reply
    1. pattu

      They are not supposed to beat equity indices. They will not work in bull markets! Underperformance is only because of the investing strategy. They don't have enough equity exposure, when they should.

      Reply
  23. jenit shah

    Hi sir,
    here you have provide nice article. I have one doubt in my mind in the country like japan where bond yeild very low while japan stock pe ratio is at 22.is this statistics also apply country like japan where bond yeild very low?

    Reply
  24. jenit shah

    Hi sir,
    here you have provide nice article. I have one doubt in my mind in the country like japan where bond yeild very low while japan stock pe ratio is at 22.is this statistics also apply country like japan where bond yeild very low?

    Reply
  25. Jagbir

    Sir, I am unable to view any of the charts in this article. I face similar problems with most of your articles. Please HELP

    Reply
  26. pawan

    these NFO brochers never include expense ratio. As soon as expense ratio is added in calculation all the premium in returns we see get absorbed by AMC as fund fee. Fund of fund have dual expense ration one for the actively managed fund and the other for fund of fund. This sums upto 5% aprox per annum. This is huge huge. Sebi should limit such expense ratio. Or its better investors avoid such funds.

    Reply

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