Compartmentalise your Portfolio

At Value Research, we are staunch believers in the virtues of diversification. It is the cornerstone of sound portfolio construction. Being diversified does not make your portfolio risk-free, but it does ensure that your savings won’t get wiped out when the markets crash.

Essentially, diversification is beneficial because a collection of investment assets together carry lower risk than an individual asset. That this is true can be understood intuitively: many asset classes are negatively correlated to each other. For example, when the stock markets fall, gold prices rise, and vice versa. Hence, if you diversify into both stocks and gold, your portfolio is unlikely to suffer a drastic erosion in value at one go. Having both the assets thus lowers the overall risk of your portfolio than having just one.

Sometimes the benefits of diversification work within an asset class as well. You might find two stocks that are negatively correlated with each other. For instance, stocks of commodity-producing companies and stocks of commodity-consuming companies are negatively correlated with each other.

In reality, it is difficult to find asset classes that have perfect negative correlation with each other, i.e., having a correlation of -1. One should also remember that the correlation between two assets does not remain constant but changes with time.

The practical application of diversification stumps many investors. Many a times, when investors send us their portfolios for evaluation, we find that even after buying 20-25 mutual funds, their portfolios are not adequately diversified, or are sometimes excessively diversified. In the former case, the reason could be that their investments are heavily concentrated in one or two thematic or aggressive funds. If that sector, in which one is heavily concentrated, underperforms, it pulls down the performance of the entire portfolio. In the latter case (where the portfolio is over-diversified), none of the funds has adequate weight in the portfolio. Even if a particular fund performs well, it does not have enough weight to be able to pull the overall portfolio return up. Thus, excessive diversification can also be a bane.

When investing directly in the markets, a common mistake that investors commit is to invest too heavily in a particular sector. By doing so, they try to chase the momentum in a sector that is currently hot. So long as the momentum lasts and the markets surge upward, such a strategy pays. But if the markets get overheated and crash, the momentum sectors bear the worst brunt. Having gained the maximum during the bull run, they also tend to fall the hardest when a correction sets in. Often after a savage downturn, there is very little left to salvage from the portfolios of such momentum chasers, as punters who had bet heavily in real estate stocks found out after the 2008 crash. Making concentrated (rather than diversified) bets is thus an all-or-nothing strategy, better suited to speculators than to conservative investors.

One way to achieve diversification (within equities) is to invest in exchange traded funds. Your money automatically gets distributed among 30 (if you invest in the Sensex), 50 (Nifty), or 500 (S&P 500) stocks, depending on which index you choose to invest in. But many investors are not willing to give up active management altogether, as is evident from investors’ interest in actively-managed mutual funds, and the growing number of share-trading accounts. There is a need for convergence between the two schools (passive and active investing) of thought. The idea of a core and a satellite portfolio offers exactly that. We believe that active investors should follow this hybrid strategy, having a core portfolio that requires very little maintenance, and a satellite portfolio where they can follow a more active management strategy to take advantage of the opportunities that arise in the market. Pursuing such a dual strategy will allow you to take advantage of market opportunities without putting your entire portfolio at risk.

Advantages of a dual approach
A portfolio is primarily subject to three risks: interest rate, equity market, and active. The first two — interest rate and equity market — constitute “market risk” (beta), meaning risk associated with bond or stock market movements. Active risk comes from the pursuit of non-market related return (alpha) through active, skilled portfolio management. Through a core and a satellite approach to portfolio construction, you can separate these two sources of portfolio risk. The core portfolio will offer a market rate of return commensurate with beta. The satellite portfolio will seek alpha, the return that can be generated by your or the fund manager’s stock-picking skills.

The core portfolio should comprise the major part of your total portfolio. It should be comprised of traditional asset classes that can serve as anchors to the portfolio. Satellite holdings, on the other hand, should constitute a smaller portion of the portfolio. They should be used to implement higher risk-return strategies that can potentially enhance a portfolio’s total return.

Over the long run costs have a considerable impact on portfolio returns. Implementing the beta strategy in the core portfolio is inexpensive as exchange traded funds (ETFs) and index funds have low costs. On the other hand, pursuing alpha is expensive. The expense ratio of an actively-managed fund is higher. Creating alpha also requires frequent trading, and that too can push up costs. By pursuing a core and a satellite strategy, you can average out costs (actual cost will depend on your allocation to the core portfolio and to the satellite portfolio).

Constituting the two portfolios

The core portfolio should be comprised of passive asset classes like index funds and ETFs. The actual choice will depend on the investor’s risk appetite. Active investors could choose to have an equity diversified fund as their core portfolio holding and have high alpha-generating asset classes like mid- and small-cap funds, sector funds, stocks, etc as their satellite holdings.

The most optimal strategy, however, would be to have ETFs in the core portfolio since they can offset the risk of active funds underperforming their benchmark index.

The main advantage of this strategy is that it is flexible and can be modified according to the investor’s risk appetite.

Within the core portfolio, one can also practice strategic allocation (see details in box: Strategic and tactical allocation).

An investor can also create a debt portfolio on the same principle by keeping fixed-return instruments in the core portfolio and having credit opportunity funds and gilt funds in the satellite portfolio.

Strategic & tactical asset allocation

Other types of portfolio construction approaches also exist. Strategic and tactical asset allocation are two of the most important ones.

Strategic allocation

The primary goal of strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon.

The most common example of this strategy is where one picks up a few equity mutual funds or stocks and then balances them with a certain percentage of bond funds or fixed-income assets (fixed deposits, public provident fund) that’s suitable for one’s age or risk appetite. Here you have to regularly rebalance your portfolio so that the asset mix does not get skewed away from your target.

Over time, either stocks or bonds will outperform the other and make you overweight in one asset class and underweight in another. By rebalancing back to your target you are effectively taking some of your profits by selling high and reinvesting it in the asset that is lagging, thus buying low. But many a times investors don’t do this, resulting in a misbalanced portfolio.

Tactical allocation

Here an investor takes a more active approach that tries to position the portfolio into those assets, sectors, or individual stocks that show the most potential for gains.

Tactical investors don’t like sitting on a few index funds for years at a time. Instead, they try to ride the market and buy into asset classes that are on the move. Generally investors follow this strategy without realising they are doing so.

You can very well understand that this type of asset allocation is riskier because it takes an active approach. Anyone can enjoy a hot streak or get lucky, but don’t forget that even the best money managers in the world can’t consistently outperform the markets. This strategy is usually not well-suited for long-term assets such as those meant for retirement. But if you limit this strategy to a small portion of the overall portfolio you can try to take advantage of moves in the market without putting everything on the line.

Impact of DTC

Till now the tax structure has never penalised investors for chopping and churning after one year. For equity investors tax on long-term gains (profits booked after one year) is at present nil. But with the implementation of the Direct Tax Code (DTC) all this is likely to change. Short-term gains will be added to the individual’s income and taxed according to his/her tax slab. Long-term capital gains will be added to your income after adjusting for deduction at a specified percentage of capital gains, based on the holding period, and taxed as above. Though the amount of deduction hasn’t been disclosed, this is a game-changing piece of tax regulation.

Post-DTC being a tactical investor (see box) will be expensive as taxation will reduce your returns. Therefore, having a significant part of your portfolio where you do not need to do any selling will reduce your tax burden.

This article was originally published on September 28, 2010.