Ukraine war a wake-up call to investors with a home bias

The world witnessed an unwelcome geopolitical event this month that has escalated quickly and led to increased market volatility. However, Indian investors and advisors seem to be coping with this quite well, as over the years, the focus has been on getting the asset allocation and diversification right, rather than dwelling on events beyond their control. The ongoing conflict between Russia and Ukraine has once reiterated the importance of diversification.

Asset allocation is the practice of spreading one’s investment across multiple major asset classes. The objective of doing this is to have control over both expected returns as well as the expected risk to the portfolio. This can be achieved by mixing uncorrelated asset classes in various combinations. Uncorrelated assets simply means having two assets that behave differently under the same market conditions. For example, gold has during warlike situations provided a safe haven to investors. Equities have declined in general in a similar case. We can observe this low correlation between gold and equities in the recent phase also. Thus, having gold and equities in a portfolio, according to an investor’s risk appetite, can be beneficial.

Diversification, on the other hand, is the practice of deciding allocation within a particular asset class — say, within equities, large-cap, mid-cap, small-cap or sector-wise. This is done after you have set up your overall asset allocation. The system can further reduce the expected risk, while keeping the expected return within a range. For example, asset allocation may refer to investing in assets such as equities, debt and gold in various combinations. An equity-heavy portfolio can be expected to have higher risk-reward characteristics than a debt-heavy portfolio. The thing to keep in mind is that research has shown that diversification beyond a point doesn’t reduce the risk any further and over-diversification should be avoided.

The same was reiterated this month as single country and single currency risk came to the fore. The Russian ruble dropped 52% between January 28 and February 28 and the Russian stock market, as indicated by the MOEX Index, dropped 25% between January 26 and February 28. In the same time period, the MSCI All Country World Index delivered returns of -0.04% and the MSCI Emerging market index declined by only 3.3%. Exposure to any single currency/country or even one theme exposes investors to greater risk and leaves the portfolio vulnerable to such events.

This is an opportunity for investors and advisors to revisit their long-term portfolio allocation strategy towards internationally diversified funds. The well-known home bias of investors everywhere can be looked into during this phase of the markets.

Home bias refers to the tendency to over-allocate to the home market, because of familiarity and consideration of costs and taxation and added currency risk. However, Indian investors, through mutual fund feeder fund (FoF) route, can overcome such biases with ease. Investors can keep aside 10%-15% of their allocation to international funds, to begin with, and adjust it according to their profile and requirements.

International feeder FoF route has been suspended temporarily as the limits for overseas investment are currently breaching the regulatory threshold. Be in touch with your advisors to keep yourself updated about this reroute reopening.

The point is that diversification should be applicable to all aspects of investing. Within domestic fund allocation also, one must diversify as far as possible. Investors can look for style diversification and perhaps look for schemes with low overlap with peers to achieve their objectives.

(The author, Ajit Menon, is CEO, PGIM India Mutual Fund. Views are his own)

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