As market valuations get stretched, investors are beginning to worry about investing at high levels. PE-based asset allocation funds can take care of this dilemma.

With valuations having moved into the expensive zone, he wonders if he should continue investing in equities. The trailing Sensex PE is now at 19.22 compared to its 10-year average of 18.90.

Advantages of PE-Based Funds

One factor that prevents retail investors from earning optimal returns in the equity market is their own behaviour. They rush into the market when it has already run up. When the market falls and their returns turn negative, they stop investing. Some compound their woes by booking losses. Thus, they miss out on the upside when the market rallies next. Price-to-earnings (PE) ratio based asset allocation funds protect investors from this cycle of greed and fear.

These funds stick to a rigid set of PE bands that determine equity and debt allocation. As the market moves up and along with it the PE ratios of key indices, these funds reduce their exposure to equities and move into debt. When the market falls, they begin to increase their equity exposure, thus always buying low and selling high.

In these funds, investors do not have to worry about high market valuations, as is the case at present. And when the market crashes and there is pessimism everywhere, they decline much less than diversified-equity funds. In 2008, the Sensex fell -52.45%, diversified equity funds on an average fell -55.41%, while Franklin India Dynamic PE Ratio FoF fell by only -25.74%. When investors see a steep erosion in the value of their portfolios, they discontinue investing in equities. By declining much less than the market index in a crash, these funds give retail investors the confidence to continue investing in the market.

Their disadvantages

In a bull market, these funds are likely to underperform broad market indices and also the diversified-equity category. Over the past one year, the Sensex is up 39.54%, diversified equity funds are up 63.79% on an average, while these funds have given an average return of 30.43%. The tax treatment of these funds can also be disadvantageous at times. If you are exiting these funds in a year when their annual average exposure to equities has been less than 65%, you will get the tax treatment given to debt funds.

Key decisions

Most PE funds invest based on trailing PE, while HDFC Dynamic PE Ratio FOF uses forward PE. Both methods have their pros and cons. A trailing PE is based on actual earnings figures and is not subject to the estimation errors that plague forward PE. The point in favour of forward PE estimates is that the market reacts to expectations. So forward PE based funds are likely to respond faster to valuation changes. Next, check the PE ratio bands of these funds, which vary considerably. The fund you choose should not have a higher equity allocation than your risk appetite permits.

Who should invest?

Only investors with a 7-10 year horizon should invest in these funds. Stay invested across market cycles to reap the benefit of their disciplined approach. Conservative investors with a low risk appetite should opt for these funds. Those with greater tolerance for volatility and a long horizon should stick to diversified funds. While the ride will be more volatile, those funds will give higher long-term returns. Consult a CFP to learn about your risk appetite. Unless you have already lived through a market crash, it may be lower than you think.

1.ICICI Prudential Tax Plan

2.Reliance Tax Saver (ELSS) Fund

3.HDFC TaxSaver

4.DSP BlackRock Tax Saver Fund

5.Religare Tax Plan

6.Franklin India TaxShield

7.Canara Robeco Equity Tax Saver

8.IDFC Tax Advantage (ELSS) Fund

9.Axis Tax Saver Fund

10.BNP Paribas Long Term Equity Fund

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