Value averaging: Rule-based approach to round-trip investment

Many investors use Systematic Investment Plan (SIP) offered by asset management firms to build their portfolios. We discussed in this column last year why SIPs are behaviourally optimal. During the last 12 months, however, investors seemed to have faced certain issues with SIPs.

This article discusses one such issue. It then explains value averaging, a rule-based approach to round-trip investment that enables investors moderate this issue associated with SIPs.

Reinvestment regret

Suppose a person decides to invest Rs 10,000 every month in an index fund. As the Net Asset Value (NAV) increases, the number of units that an investor can buy for Rs 10,000 decreases. This appears to be a problem for some investors, as fewer units mean lesser upside participation.

A greater problem, however, is in taking profits and reinvesting the amount in a wobbly market, as has been the case in the last 12 months. The reason is that SIP concentrates only on investing, not on taking profits. For that, investors have to set up Systematic Withdrawal Plan (SWP). An SWP is appropriate for retiree-investors who take profits to consume cash flows.

Non-retiree investors have to decide when to move the cash back into the assets. The problem is that wrong market timing would cause regret, leading to an aversion to equity investments. It is, therefore, important to set-up rule-based approach to round-trip investing. Value averaging is one such approach.

Value Averaging

Consider a person who wants to invest Rs 10,000 every month. The investor will initially buy 1,000 units in index fund, assuming NAV of Rs 10 a unit.

If the NAV moves to Rs 14 in the second month, the investor need not buy 715 units (Rs 10,000 divided by Rs 14) as in the case of an SIP. Instead, the computation works this way: the portfolio has Rs 20,000- 10,000 in index funds purchased the previous month and Rs 10,000 cash allocated for current month`s purchases. At an NAV of Rs 14 a unit, the portfolio can hold 1,429 units. As it already has 1,000 units, the investor has to buy only 429 units, using Rs 6,006.

Suppose the NAV climbs to Rs 25 the month after. With another Rs 10,000 scheduled for that month`s investment, the total portfolio value would now be Rs 30,000. At an NAV of Rs 25, the portfolio ought to have 1,200 units. And it already has 1,429 units. The investor has to, hence, sell 229 units.

Side pocket

But what if the NAV declines sharply to, say, Rs 20 the following month? At Rs 40,000, the portfolio ought to have 2,000 units whereas it only has 1,200 units. The investor now has to buy 800 units, which amounts to Rs 16,000. The scheduled monthly investment is only Rs 10,000. From where will the investor get another Rs 6,000?

Enter the side pocket account. An investor should typically operate a money market fund along with the investment account. During months where the investment account sells units, the proceeds will be swept to the money market fund — the side pocket. This side pocket will provide cash during months when investments higher than the scheduled contributions are required.

It is important to understand that the side pocket account has zero risk-tolerance. The objective is to protect capital, earn cash returns and finance shortfalls in the investment account.

Value averaging essentially sells units when prices climb sharply and buys more when prices fall sharply. This approach is optimal when prices are volatile and not trending. It can be easily applied on ETFs, as short-term selling will attract exit loads on open-end funds.

The approach can be useful within the core-satellite framework. It can be especially applied for creating retirement portfolios. Investors require expected return on investment, the investment horizon and the monthly contributions to set-up an optimal value-averaging plan.