Mukesh Dedhia - one of Mumbai's leading financial advisors, is also a leader in the field of academics in the financial advisory space in the country. Academicians who are practicing advisors bring to the table a very useful practical perspective to their learnings and insights. That's what Mukeshbhai has done in this interaction with Wealth Forum, where he shares his incisive insights into an aspect of financial advice that is sometimes less focused on, but which is increasingly becoming more and more relevant : risk management. Mukeshbhai takes us through what advisors need to do to better understand risk and then apply these understandings in managing client portfolios. This article is a part of FIFA Perspectives - the monthly newsletter that Wealth Forum prepares jointly with FIFA.

WF: Why do you believe that advisors need to increasingly focus on risk management when advising clients and not just on adding alpha? In what ways would you suggest that advisors do this?

Mukesh Dedhia: Today we are in a volatile world. There are two sides to the coin- risk and returns. After the global crisis it has become more important to manage the risk. We are not sure if we will get the historical returns as we were used to, within a reasonable period of time. For the last five years the Indian markets have hardly moved anywhere. In 2007 the Sensex was at 18000 and today in 2012 it is still around that figure with many bouts of volatility inbetween. Similar bouts of volatility are seen in the interest rates also. There are many other factors like the commodity market especially the crude prices; the foreign currency; India's fiscal deficit etc. We are now importing inflation due to abundant global liquidity, apart from having our own inflation challenges. These considerations have become very important.

We need to look at correlation between various assets. Conventional wisdom suggests that we need to have a diversified portfolio with assets that have negative correlation. But in times of crises, this does not hold true and unfortunately the assets that were having negative correlation start exhibiting positive correlation. So in uncertain times the risk suddenly increases and we have seen the global banks like the Lehman and Bear and Stearns are coming down. So many banks are folding up in the US. So it is important to manage risks.

When it comes to the investor he is finally concerned with the returns. Our job as advisors is to look at the risk aspect. Risk profile of assets is also a dynamic variable - which very few of us really appreciate and apply. When we look at beta, beta is a historic number. Conventional wisdom suggests that equity is riskier than debt. Take an example of 2009, when the index was low at around 8000 and the interest rates were also low. If you look at risk dynamically, you will appreciate that debt in that circumstance was in fact riskier than equity, as the possibility of loss of capital from debt funds due to increases in interest rates was perhaps higher than loss of capital from equity funds when market P/E was in single digits. Our job as advisors is to understand how the risk and return profile of various asset classes keeps changing, in response to macro developments. Making our clients understand risk of asset classes at that point of time is more relevant than a fixed notion of risk of each asset class.

This highlights the scope for tactical allocation that takes into account risk management. There is always a debate between tactical and strategic asset allocation. Investors always ask about the value that the advisor added. When you are passive, you are not adding any value you are just rebalancing your portfolio by asset allocation. Asset allocation is required. I don't want to say that we time the market very well but we can definitely understand the risk, the relative risk at different points of time. Advisors can measure this relative risk and thus will be able to add value, which is important. They need to keep a watch on the equity markets, interest rates, commodity markets, crude oil prices, gold prices and foreign currency movements as these factors will have impact on different assets in different ways at different points of time.

WF: In the industry, we often talk about SIPs for retail investors and strategic asset allocation with periodic rebalancing for HNIs. Is there a meaningful role for an advisor to go beyond this and into either tactical asset allocation or any form of risk management strategies?

Mukesh Dedhia: Absolutely. If an investor has been doing a SIP for 10+ years and he has accumulated over a crore of rupees, you can't still talk about just continuing with that SIP alone. Yes, he should continue with the SIP, but the advisor must understand that the portfolio is large today in absolute terms. The advisor must think not only about continuing the SIP but also about protecting the capital already created. Keeping the portfolio in a long only position, is like a naked position as the investor is not protected on the downside and you need to protect that value. NAVs of funds had crashed up to 80% in the last fall. In Japan even after 20 years the markets are not recovering. In China, which has the maximum GDP growth, the markets are doing very poorly. You cannot just talk about long term and do nothing about protecting the capital that has been so painstakingly built up.

WF : What protection strategies would you suggest advisors consider in this context?

Mukesh Dedhia : Advisors must be open to considering structured products that are suitable to their clients' needs and which help in protecting the downside. The advisor has to manage risks continuously even in structured products. Market risk and credit risk has to be managed. The advisor has to check the issuers, their credit ratings and their past experiences. Then also a diversification would be required.

Structures need not always be viewed from a return perspective. They have their utility in helping an investor avoid making a mistake in panic. Take a case where an investor had a long position when the market was falling in 2008 or more recently when we saw a sub 16000 level last year. Many investors panicked in these falls and exited their equity fund holdings. If instead they had structured products that gave them downside protection, they would have the confidence to ride out the volatility and gain from the subsequent upside. The benefit of structured products is mainly risk mitigation rather than chasing returns.

WF: We've talked about what advisors should do in terms of risk management. The other big stakeholder in risk management is the fund manager to whom the money has been entrusted. What role do you see fund houses discharging in this aspect?

Mukesh Dedhia: We normally create client portfolios on the basis of certain asset allocation which is based upon some expected returns from various asset classes and the risk profile of our clients. As I had mentioned earlier, the return expectations and risk profiles of asset classes themselves are dynamic and not static - and advisors must recognize that in their overall asset allocation decisions.

The market reality is that in the retail world, most often clients are just buying products without the benefit of a proper asset allocation process like what I have just mentioned. Here the role of the fund manager is more important as he is managing the portfolio on a day-to-day basis. He knows the risk factors. In the last one year, dynamic income funds have become popular, as the fund manager is able to change the duration of the portfolio taking into account the various things happening in the economy.

Initially the equity fund always had large caps and mid caps as exclusive product sets. But now there are Dynamic funds or Equity opportunities funds or multicap funds and they have been more popular because in a portfolio you need to have a dynamically changing mix to take the advantages of changing market situations. Certain flexibility today needs to be given to the fund manager and if he can move across assets classes also and does his job well, investors could prefer those types of funds.

If you look at Edelweiss Absolute Return fund, which is an equity fund that uses derivative strategies among others, in 2011 when the NIFTY crashed by 24% this fund was down only by 2.3%. These types of funds will participate to the extent of about 60% to 70% of the upside but on the downside it is able to very well protect you. When you take different cycles it can be a winner over a long only fund. Today if you take a three-year history it has performed better than the large cap funds. We need fund managers who not only participate in the upside, but look for strategies to protect on the downside too.

We have to understand one reality - all clients are risk averse, irrespective of what the risk profiling document says. Once we understand this, we will automatically pay a lot more attention to risk management than only focusing on the alpha generation possibilities.