So far in this series on defensive investing we have understood the fundamental concepts driving the defensive approach. We have also understood what it takes to become a successful defensive investor. Finally we understood why the defensive approach would ideally suit most investors. This sets the stage nicely for a discussion on building portfolios that are oriented to the defensive approach.
To begin this discussion, we must understand the objectives a defensive portfolio must achieve. A well constructed defensive portfolio must allow the investor :
1. To lay emphasis on avoiding serious mistakes and losses, and
2. To avoid the effort and frequent decision making involved with fund research and selection.
3. To gain diversified exposure to asset classes at justifiable costs.
In other words defensive portfolios must be simple, low cost and well diversified. Apart from these criteria, the investor must have a clear goal and asset allocation strategy in mind.
Index funds therefore become an ideal option for the equity allocation in any defensive portfolio. The trend of using index funds to construct equity portfolios is gaining traction among Indian investors. I have myself explained the benefits of using index funds in portfolios in a number of my earlier articles.
But our understanding of the process behind picking index funds needs more clarity. Therefore I am now going to talk in detail about the nuances involved in the process of picking index funds.
Index funds and Exchange Traded Funds (ETFs) are the two primary avenues used for passive investing. Let us first understand the process behind picking index funds. When picking index funds, the first criterion is the choice of a benchmark index. Investors must primarily stick to funds that are benchmarked to the Total Returns of a large cap index. It is important to pick funds from fund houses that are at least 10-15 years old. Schemes must be chosen under the Direct Plan, Growth Option. Any scheme chosen must have been in existence for at least 10 years.
Any index fund investors pick must be adequately liquid. This would ensure ease of transactions and minimise impact costs. Investors must therefore choose from funds that have an AUM (Assets Under Management) of at least Rs 1,000 crore.
Costs are the next important factor that investors have to consider. An annual expense ratio of 0.2% would be a fair fee to pay for a large cap index fund. We further have to ensure that costs remain around the benchmark of 0.2% per annum for the foreseeable future.
The ideal category for equity index fund investing in India would be Nifty 500. The Nifty 500 index offers exposure to all segments of the Indian equity markets (large cap, mid cap and small cap). As of today, Motilal Oswal offers a Nifty 500 index fund that satisfies both the AUM and expense ratio criteria as discussed above (Current AUM around Rs 1,105 crore; current expense ratio 0.13% per annum).
But this is a very recent development. Motilal Oswal is currently the only major fund house that offers a viable Nifty 500 index fund. This means that there is a lack of competition among fund houses in this category. So costs may not remain competitive over the long term. Also, the benefits of additional diversification offered by a Nifty 500 index fund over a Nifty 50 index fund are minimal at best. This means that it may be too early to consider Nifty 500 index funds for our portfolios.
Therefore investors should primarily stick to picking funds that track the Nifty 50. Every fund house in India offers a Nifty 50 index fund. The intense competition between fund houses would ensure that costs remain around the current levels over time. A fund costing 0.15% per annum would be no different from one costing 0.2% per annum. Investors must therefore not nitpick between funds on the basis of costs.
Investors who wish to go beyond Nifty 50 may ideally restrict themselves to Nifty Next 50. A Nifty Next 50 index fund would be available with most major fund houses at an expense ratio of 0.3% per annum. This would be a fair expense ratio to pay for a Nifty Next 50 index fund. But investors must acknowledge that including a Nifty Next 50 component in the portfolio would heighten risk and volatility.
Investors may want to use a metric to evaluate the performance of index funds. A metric called tracking difference would be ideal for this purpose. Tracking difference = Fund return – Benchmark total return. The resultant value of tracking difference calculations is usually a small negative number. This is because the return of the fund is typically lower than the total benchmark return. This difference arises since the expenses of the fund are constantly deducted from its NAV. The tracking difference of an index fund can be calculated for any given time period. It accounts for the fund’s expenses and deviations in following the benchmark. It therefore makes evaluation of fund returns more intuitive.
There is also the option of adopting the defensive approach using equity ETFs. But investors must understand that ETFs have limited utility. ETF units are traded in the secondary market. Hence there may be mismatches in demand and supply. In such cases, the price of an ETF can deviate significantly from its NAV. ETFs may also have liquidity issues. So there may be situations where the desired quantity of ETF units cannot be sold at a given point of time. So most investors are better off avoiding ETFs completely.
But ETFs may be relevant for investors who have a low cost broking account. Such investors may consider a Nifty 50 ETF. They may pick an ETF with robust daily trading volumes (at least 1,00,000 units traded everyday) and no history of paying dividends. A cost 5 to 6 basis points would be a fair price to pay for a Nifty 50 ETF. ETF investors must remember that transactions are executed at the ETF’s price. They must hence remember to compute tracking difference using the price of the ETF and not the NAV.
Investors must remember that all index funds simply mirror the returns of their respective benchmarks. It therefore makes no sense to try and pick ‘the best index fund’. It is also futile to try finding the fund with the highest AUM, lowest expense ratio or lowest tracking difference. All investors need to do is to shortlist a set of index funds that satisfy the filters given above. They can simply pick a couple of funds from the shortlist in line with their goals and intended asset allocation. Regular rebalancing and reduction of equity allocation may be carried out as required. This would make the exercise of constructing and maintaining the equity component of portfolios much simpler.
A quick review of the criteria for picking index funds :
Stick to Nifty 50 and Nifty Next 50 index funds
2. Expense ratio of 0.2% per annum or lower (Nifty 50), and 0.3% or lower (Nifty Next 50)
3. Minimum AUM of Rs 1,000 crore
4. Minimum life of the fund should be 10 years
A quick review of the criteria for picking equity ETFs :
Stick to Nifty 50 ETFs
2. Low cost brokerage account
3. Daily trading volume of at least 1,00,000 units
4. No dividends paid out by the ETF
5. Expense ratio of 5 to 6 basis points (0.05% - 0.06%) per annum
Let us now look at options to construct the debt component of a defensive portfolio. The essential objective when building the debt component of a defensive portfolio is not to chase returns. The primary goal of the exercise must be to mitigate credit risk and interest rate risk. (These concepts have been explained across the six graphics given below. Click the first graphic and swipe right to view each graphic in detail.)
Tax advantaged schemes offered by our employers and the government (EPF, PPF, Sukanya Samriddhi Yojana) become ideal candidates for a significant portion of the debt component for long term goals. It is hard for most market linked debt products to beat the long term post tax returns offered by these schemes.
But the major drawback of these schemes is the obvious lack of liquidity. This makes rebalancing the portfolio from debt to equity challenging whenever required. Therefore a part of the debt component for long term goals can be parked in liquid funds and money market funds.
These debt mutual fund categories are highly liquid. The credit risk and interest rate risk associated with these categories is lower than most others. They facilitate smooth rebalancing of the portfolio whenever required. They therefore become ideal candidates for both short term and long term goals. Investors would benefit from picking any liquid and/or money market fund that satisfies ALL 3 criteria given below :
An annual expense ratio of 0.2% or less
2. Minimum AUM of Rs 1,000 crore
3. The fund should have been in existence for at least 10 years at the time of purchase.
Let us now look at some simple guidelines for asset allocation and rebalancing under the defensive approach. For any goal that is 7 or more years away, upto 60% of the portfolio can be allocated to equity. For goals that are more than 5 but less than 7 years away, 10-20% of the portfolio may be parked in equity.
Finally for goals upto 5 years away, it is best to avoid equity altogether. This is because the standard deviation in equity returns over periods upto 5 years is very high. This means there is no way for investors to reliably judge the behavior of equity as an asset class over such periods. It therefore is not prudent to have equity exposure for such goals.
Let us now look at rebalancing under the defensive approach. Here, we do not necessarily rebalance at periodic intervals. An initial asset allocation is set for each goal. After that, threshold limits are set for each asset class in the portfolio. Any time the allocation to any asset class deviates by more than the threshold limit, we rebalance the portfolio.
For instance, say we begin with a 60-40 allocation to equity and debt for a particular long term goal. A 5% threshold limit is set. Any time the equity allocation rises to 65% or falls to 55%, we rebalance the portfolio to the original 60-40 allocation. Apart from this, regular derisking of the portfolio is carried out. This is done by periodically reducing the equity allocation in the portfolio as the goal comes closer to falling due. This makes the portfolio less vulnerable to sequence of returns risk.
That concludes this three part discussion on defensive investing. As we have seen across the series, the defensive approach is born from a sound conceptual framework. It is simple and easy to follow. It employs products that do not require too much effort to manage once the portfolio is set. Most active management strategies will not do better than a well constructed defensive portfolio over the long term after accounting for taxes and investment costs. The defensive approach would therefore give most investors a viable chance of achieving their financial goals.
Links to the first two parts of my series on defensive investing are given below :
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