Target returns funds: Need for style-based tactical asset allocation strategy

Target returns fund appears to be finding favour among asset management firms. Prudential ICICI Mutual Fund launched one recently and reportedly has met with good investor response. Reliance Mutual Fund has filed a document with SEBI to offer a similar fund. The question is: Are such funds optimal investments?

This article shows how such funds help investors overcome certain behavioural biases. It also explains why such funds can be a part of the satellite portfolio if they offer tactical asset allocation (TAA) strategy with style-based mandates.

Overcoming biases


Investors find it difficult to rebalance their portfolios. Sometimes, they take profits too soon.

Other times, they cut their exposure too late, both of which could lead to regret aversion bias. This is the behavioural bias that forces investors to avoid taking any decision because they feel that their actions will prove sub-optimal on hindsight.

Such bias could lead to construction of sub-optimal portfolios.

At the extreme, investors could choose to avoid equity as an asset class for fear of sub-optimal entry into and exit out of the market.

Target returns funds help in this regard. Such funds provide pre-determined triggers to move money from equity to bond funds, thus, lowering the regret aversion bias. ICICI Target Returns Fund, for instance, allows trigger-based switch of either the gains or the entire investment to one of the four bond funds offered. The above strategy also helps investors in keeping their capital-at-risk constant.

A person who sweeps the gains into a bond fund through pre-determined trigger levels will continue to expose only the initial capital to equity price risk. This helps investors overcome yet another behavioural bias.

Investors tend to take greater risk on the money gained from capital appreciation compared with that on their initial capital.

Just as gamblers risk their winnings because the money is coming from the “house” or the casino.

That said, target returns funds should provide certain important features to make them attractive within the core-satellite portfolio framework.

Need for TAA


Target returns funds fail to address the issue as to what investors should do after they have swept the gains into a bond fund. Should they switch back to equity after asset prices decline?

This factor is important because regret aversion bias would paralyse an investor from taking further action. The upshot is that gains will continue to remain in a bond fund, perhaps, earning sub-optimal returns.

That is why asset management firms should offer pre-determined switch-back triggers as well.

A decline of 10 per cent in the benchmark index, for instance, should lead to switch-back from bond funds to equity funds. In other words, investors require funds to offer TAA strategy — a dynamic strategy that can adjust allocation among asset classes based on pre-determined trigger levels.

Besides, such funds should offer distinct investment styles so that the same can fit well within the satellite portfolio. The objective of this portfolio, within the core-satellite framework, is to enable investors to take bets on short-term trends with a view to beating the benchmark index (alpha returns).

At present, target returns funds are structured to take exposure to large-cap stocks. The problem is that large-cap exposure is best taken through an index fund, as it is difficult to generate alpha returns in the large-cap space.

Conclusion


It would be optimal if asset management firms offer style-specific non-large cap funds within the target returns universe. Till then, investors could engage in a DIY (Do-It-Yourself) target returns strategy. This involves a two-step process. The first step requires pre-defining the sweep-out and sweep-in triggers based on the investor’s risk tolerance level. The second step involves pre-selecting equity and bond funds to use as a vehicle to take the required asset exposure.

One drawback is that DIY strategy would attract an exit load if the switch happens within six months of the initial investment.