Personal Finance

Designing an ETF strategy for self-managed portfolios

B. Venkatesh | Updated on April 30, 2011 Published on April 30, 2011

It is possible to draw up an attractive strategy using ETFs that is easy for investors to execute within the core-satellite framework.

An investment strategy should satisfy two important tests to be considered attractive for self-managed portfolios. One, the strategy should be easy to implement; and, two, it would provide attractive risk-adjusted return.

Often, investments that offer good returns are difficult to implement. The question is: How can investors create an attractive strategy that is easy to execute?

This article discusses an ETF strategy that arguably passes both the tests. It also explains how the strategy can be implemented within the core-satellite portfolio framework.

Simply ETFs

ETFs are good investment vehicles for individual investors for two reasons. One, ETF is a passive structure. So, individuals need not worry about evaluating portfolio managers. That is, all ETFs on the Nifty, for instance, will generate same returns, if they have the same management expense ratio (MER). Buying active funds, on the other hand, requires clinical evaluation of portfolios to identify sustainable alpha-generating managers, which is not easy.

Two, ETFs are listed on the stock exchanges. This provides opportunities for individuals to buy-sell ETFs and profit from short-term market movements far more efficiently than they can with index funds.

Next, consider how ETFs offer attractive risk-adjusted return. ETFs capture style trends and, hence, can generate handsome returns. That is, if large-caps perform better than mid-caps, Nifty ETFs ought to do better than active large-cap funds because the latter will also have some exposure to mid-caps. In other words, ETFs provides pure exposure to an investment style and, hence, offers attractive returns.

True, active funds can do better than ETFs when large-caps and mid-caps move together. But active funds carry active risk. This risk arises because such funds deviate from the benchmark index in the hope of generating higher returns. Sometimes, the active risk pays rich returns. Often, however, it leads to underperformance, as active funds do not continually generate alpha. This leads to large volatility in year-on-year returns, lowering risk-adjusted returns. ETFs offer handsome returns without active risk, as they simply hold securities in the same weight as those in the underlying index.

The question: How can investors use ETFs to create simple strategies within the core-satellite portfolio?

Core-satellite ETFs

Our strategy uses ETFs on Nifty, Junior Nifty, mid-cap and gold. The core portfolio provides passive exposure to preferably a broad-market index or alternatively to a large-cap index. The satellite portfolio provides active exposure to assets than strive to beat the benchmark index.

The strategy requires investors to use systematic investment plans (SIPs) on the core-satellite portfolio. SIPs are optimal for two reasons. One, it eliminates the need to time the market and, hence, moderates portfolio losses; two, it provides a disciplined approach to savings.

Our strategy on the core portfolio requires the investor to set-up an SIP on Nifty ETF. This requires the investor to choose the time horizon and dates during which the ETFs will be bought each month.

An individual can, for instance, set-up an SIP for 36 months to be executed on the first Wednesday of every month. The time horizon should necessarily coincide with the investment objective. That is, if the investor creates a portfolio to fund her child's education 5 years hence, the SIP should be set-up for 5 years.

The strategy on the satellite portfolio requires the investors to set-up SIPs on Nifty, Junior Nifty and mid-cap indices and gold.

Besides providing dates and time horizon, investors should also have pre-defined rules to unemotionally take profits or cut losses on the satellite portfolio. The profit rule, for instance, can require the investor to sell 50 per cent of Nifty ETF holdings if the unrealized gain is 10 per cent or more. Likewise, the risk management rule could require the investor to cut losses if the downside amounts to 5 per cent or more.

Conclusion

Investors can expand their investable universe for the satellite portfolio when more ETF products become available. The rules of the core-satellite ETF strategy are simple and its implementation, easy. The strategy will be successful only if the investors strictly and dispassionately follow the pre-defined rules.

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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