Readers of this column are aware that we like passive investing. It is small wonder then that we received a query from a reader asking us to suggest how an investor can construct a portfolio using such passive products. We have suggested how to use ETFs to create target portfolios. But the question is: What should typical portfolios contain?

This article suggests a portfolio using open-end index funds and ETFs in the market. It is important to note that the portfolio weight of each asset is generic. Actual asset allocation would depend on each investor's risk tolerance level, investment horizon and return objectives.

Why Passive?

Active management is attractive, but risky. This is because alpha or excess return above the benchmark index is a zero-sum game. That is, the excess (positive) return above the benchmark index of all active managers is equal to the excess (negative) return below the benchmark index; index return is the average return on investment.

Moreover, active managers do not consistently beat their benchmark index. Besides, not many investors have the tools to pick sustainable alpha-generating managers.

In the light of these factors, it is optimal for investors to buy passive products rather than take exposure to active funds that may well underperform the index.

By passive products, we mean ETFs and open-end index funds. These include funds and ETFs on S&P CNX 500, S&P CNX Nifty, Junior Nifty, Bank Nifty, Gold, Infrastructure and CNX Mid-cap indices.

Typical portfolio

We start with the following assumptions. One, the investor prefers 40 per cent exposure to equity, 40 per cent exposure to bonds and 20 per cent to alternatives.

Two, of the total exposure the investor prefers 55 per cent exposure to core portfolio and 45 per cent to the satellite portfolio. And three, the investor has Rs 50,000 to invest every month.

Given the structure of the fund industry and the bond market in India, it is optimal to have bond exposure primarily in the core portfolio. So, the investor is expected to take Rs 20,000 of core bond exposure every month. This exposure consists of PF, PPF, post-office Monthly Income Plans, and bank fixed deposits. We do not consider bond funds because they are actively managed.

The investor now has Rs 30,000 to invest in equity and alternatives. Of this, Rs 7,500 is part of the core portfolio with exposure either to a broad-based index fund such as the S&P CNX 500 or a large-cap (Nifty) index fund or ETF.

Of the Rs 22,500 of satellite exposure, the portfolio has Rs 10,000 in gold ETFs and Rs 7,500 in Mid-cap index or Junior Nifty. It may not be optimal to buy Mid-cap and Junior Nifty because of the significant overlap in exposure between the indices. Of the balance Rs 5,000, investors can take sector exposure, say, Bank index or theme exposure, say, the infrastructure sector.

Conclusion

The typical portfolio is generic and not custom-tailored to suit specific investment objective or risk tolerance level. It invests Rs 20,000 in equity, Rs 20,000 in bonds and Rs 10,000 in commodity every month.

Investors can spread the purchase through the month. This moderates regret bias that comes from the inability to consistently time the market.

Investors should have pre-defined rules to capture short-term profits in the satellite portfolio. Besides, investors should choose only one fund for each exposure, as all passive funds of the same type carry the same portfolio. Preference should be given to a fund that has low expense ratio and sizable assets under management.

The model portfolio will, thus, carry three equity funds, one gold fund besides bond exposure.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com. )

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