Material for Group C
Asset Allocation and Portfolio Design
(Source: Book on Portfolio Management by Professors. S.K.Barua, V.Raghunathan and J.R.Varma)
When we talk of portfolio management, all of us think of equities. In this book too, we
have tended to focus on equities except in the last chapter.
In reality, however, with the possible exception of the growth oriented mutual funds, it is
rare to find a portfolio consisting entirely of equities. In many cases, equity is not even
the largest component of the portfolio. For example, the country’s largest and oldest
mutual fund – UTI’s Unit 64 – has, in recent years, kept a larger fraction of its portfolio
in bonds than in shares. A substantial investment in bonds provides a stable source of
income to balance the unpredictable fortunes of the equity portfolio.
While equities and bonds constitute the bulk of most investment portfolios, it would be a
mistake to ignore the other components which though usually smaller are of vital
importance. Usually, a small percentage (5% - 10%) of the funds is kept in cash or in
highly liquid securities in the money market. The main purpose of these assets is to
provide transaction flexibility to a portfolio manager. They allow him to buy some
securities without having to sell some other scrip beforehand. Similarly, he may sell
some scrips, and keep the proceeds in money market instruments while he identifies the
scrips to buy. The investor who tries to eliminate money market instruments from his
portfolio would have to balance his purchase and sale of securities on a day-to-day basis;
this is usually utterly impractical. This transaction flexibility is not, however, the only
role of money market instruments in the overall portfolio. We shall see later that there
may be situations where an investor may keep an unusually large fraction of his funds in
the money market.
Asset Classes
The typical investment portfolio then has three distinct components which we shall call
asset classes:
- Equities
- Bonds
- Cash and money market instruments.
We are free to add more asset classes to this list. For some investors, bullion may be an
important asset class. In some cases, it may be useful to further divide the above asset
classes into subclasses. Individuals in high tax brackets may regard tax free PSU bonds
as a separate asset class distinct from corporate bonds. We can even think of subdividing
the equity asset class into the forward and cash list because of their different liquidity
characteristics.
In this chapter, however, we shall confine ourselves to the three asset classes listed
above.