There is a new fund category on the block—the life cycle fund. Designed to simplify asset allocation, these funds automatically shift between equity, debt, and other asset classes as investors move closer to their financial goals.
To understand how these funds work and the nuances behind the glide-path strategy, Kundan Kishore, deputy editor, Outlook Money spoke to Manish Banthia, CIO - fixed income, ICICI Prudential Asset Management Company (AMC). Here are the edited excerpts from the conversation.
What is a Life Cycle Fund? What kind of challenges does it solve for an investor?
A life cycle fund, also referred to as goal-based or target date fund globally, is designed to help an investor invest towards a specific financial goal over a defined period, while gradually adjusting the portfolio’ risk as the goal approaches. The key challenge it addresses is that the level of portfolio risk an investor can take is not necessarily the same throughout one’s investment journey.
When the goal is distant, the investor portfolio has more time to absorb market volatility and can, therefore, have a higher allocation to equity. As the goal nears, the portfolio has less time to recover from a market drawdown.
A life cycle fund addresses this dilemma by gradually shifting the portfolio from higher equity allocation towards higher debt allocation as the defined maturity date approaches through a well-defined glide path.
The term “glide path” is central to this concept. How does it actually work?
A glide path can be defined as a roadmap that determines how a portfolio’s asset allocation changes over the life of a fund. In simple terms, when the investment horizon is long, the fund starts with a higher allocation to equity. As the goal gets closer, the equity allocation gradually reduces and the debt allocation increases.
This is important because the uncertainty around equity returns becomes more significant as there is less time to recover from a potential market downturn like the ones seen during the Global Financial Crisis (2008), and the Covid pandemic (2020). Therefore, the portfolio gradually reduces its equity exposure and increases its debt allocation. The objective is not only to maximise returns, but also to reduce the risk associated with achieving an investor’s goal in a hassle-free manner.
How is a life cycle fund different from investing separately in equity and debt, or managing the asset allocation on your own?
When an investor invests separately in an equity and debt fund, the responsibility of deciding when and how much to rebalance between the two asset classes generally rests with the investor.
The risk here is that while the investor may initially choose a certain mix of equity and debt, he or she may not regularly adjust it as the goal approaches. Also, the equity portion of the portfolio can witness sharp drawdowns or volatility which can impact the corpus created.
A life cycle fund addresses these challenges through the ‘glide path’ approach. Here, the fund gradually changes its asset allocation as it moves towards its defined maturity date. Another important aspect is that the rebalancing happens within the fund, rather than the investor making those switches. This makes the strategy more systematic and reduces the need for the investor to continuously monitor and manage the asset allocation.
There are life cycle funds with different maturity years. How should an investor decide which maturity year to choose?
The maturity year should broadly correspond to the time horizon of an investor’s financial goal.
For instance, if an investor has a goal that is around five years away, a life cycle fund with a maturity closer to that timeframe may be considered. Similarly, a longer-term goal, such as a child’s education or retirement could potentially align with a fund having a longer maturity. The key is to start with the goal and its timeline.
The fund invests across multiple asset classes. How do you determine the appropriate mix of equity, debt and other asset classes at different stages of the journey?
The asset allocation methodology combines a pre-defined ‘glide path’ based on the remaining investment horizon with flexibility within the prescribed ranges to manage the portfolio across permitted asset classes.
For instance, Life Cycle Fund 2041 has an equity allocation of 65-80per cent during its first five years. Once it reaches a residual maturity of 10 years, its net equity allocation for the subsequent five years is 50-65per cent, and so on. In the case of Life Cycle Fund 2031 and 2036, the net equity allocation during the initial years is 35-50per cent and 50-65per cent, respectively, and this gradually reduces as the schemes approach maturity.
On the debt side, as the fund gets closer to maturity, the portfolio becomes more focused on higher-rated securities with appropriate residual maturity. When the fund has less than three years to maturity, exposure to debt instruments is limited to AA and above-rated instruments with residual maturity less than the target maturity of the scheme. When it comes to commodities and infrastructure investment trusts (InvITs), the exposure is restricted to 10 per cent of the net assets.
