It is possible to build a beautifully diversified equity portfolio with only sector mutual funds. The data first published with this idea in April 2014 has now been updated.
Note: what is presented below is an investment idea presented with academic curiosity and not a recommendation to abandon your existing diversified mutual funds.
Investing for long-term financial goals has a singular purpose, obtain returns that are more than the average inflation after taxes. Typically, this is possible only by using instruments that are volatile like equity.
Volatility is a double-edged sword. It is necessary to combat a volatile enemy like inflation. However, too much of it can erode the benefits of compounding.
Investing is not about returns! It is about returns with low standard deviation. That is annual returns of a portfolio should not deviate too much from the ‘average’ return. If there are wild swings, each time there is a fall, most gains would be wiped out.
I can think of at least four ways to contain the erosion of gains due to volatility:
- Asset allocation Spread your investments across investments that vary in volatility, preferably among those poorly correlated with each other. The simplest form of diversification is between equity and debt, avoiding real estate, gold, art etc.
- Diversification The investments in each asset class must be well diversified. That is, equity investment should be spread across market cap, sectors and geography and debt investments across instruments that vary in credit risk and interest rate risk (learn how to choose debt funds here)
- Rebalancing Gains made in one asset class is shifted to another to ensure the asset allocation is not skewed in favour of one asset class. You can learn all about rebalancing and play with a simulator here.
- Decumulation The assets in the volatile instruments are gradually shifted to safer instruments a few years before the money is required for the intended expense.
While asset allocation (don’t put all eggs in the same basket) and decumulation (quit while you are ahead) represent simple common sense,
Diversification (hit a moving target with a pellet gun and not a rifle) and rebalancing (keep adjusting the centre of gravity if you balancing a stick on an end!) are less obvious but equally important.
Diversifying within each asset class is most crucial in containing portfolio volatility.
The idea is simple. You don’t know which stocks will work. So just buy stocks of each variety (market cap, type, sector, geography). In any given year some of these stocks will click and others won’t. So the gains in your folio will on an average increase steadily and will lower volatility compared to investing in select stocks.
Diversification is also a double-edged sword. It will equally suppress losses and returns! That is the price you pay for investing in a volatile asset. Diversification will not work if a person does not have the maturity to understand this.
Most DIY investors fail to diversify within asset classes - primarily equity. Diversification applies to debt as well but is not as crucial, since volatility is lower. Come to think of it, NPS is a half-decent way to diversify a debt folio!
It is difficult to build a truly diversified equity portfolio with … er ... diversified equity funds! Many of us hold more than one large cap or one mid/smallcap funds. Down the line we accumulate more such funds and soon many of the funds in our equity folio will have the same set of stocks – use this tool to find out the overlap in equity portfolios.
The portfolios of diversified funds can significantly with time. Large-cap funds can increase small/midcap stock exposure beyond what we expected it to do and vice-versa. In fact some funds have even jumped categories in VR online!
So although we start out with fund with minimal overlap, this can change with time.
What is the simplest way to build an all-weather diversified equity folio? How can we ensure minimum overlap among stocks at any point in time but at the same time, minimising risk and therefore hope to obtain decent returns?
Can we find a turn-key solution to equity folio diversification? That is, once we find a method and implement it, the extent of diversification does not vary by much for the entire investment duration, with no intervention necessary by the investor.
I had earlier discussed a turn-key solution to asset allocation – The permanent portfolio. You hold 25% of equity, 25% of gold, 25% in long term bonds and 25% in short-term bonds and rebalance each year.
This has had excellent success in the US and other parts of the world. In the Indian context, tax could play spoil sport.
In this post (finally!) I discuss a turn-key solution to equity portfolio diversification: Use Sector Mutual Funds
This post is inspired by a thread in facebook group Asan Ideas for Wealth (AIFW).
A sector (equity) mutual fund is one which has a mandate to (primarily) invest in stocks of one particular sector – Health Care, Metal, Oil/Gas, fast moving consumer goods, information technology etc.
The idea behind the turn-key solution is simple. Buy different sector funds in equal proportions and contribute to them regularly. By doing so, you would have pretty much a guaranteed diversification of the equity portfolio at all times.
Okay! But what about performance?
To verify this Idea I have chosen one fund from each of the actively managed sector funds that are listed at VR online.
I have chosen funds that are 10 years old. So in each sector, I only had 2-3 funds to choose from. Among these ,I picked the ones that were most consistent as outlined in the step-by-step guide to selecting an equity mutual fund.
As always star ratings were ignored! The funds chosen were,
In the case of infrastructure funds, the one from UTI was the only 10-year-old fund.
NAV history from AMFI is available only from Apr 3rd 2006. So to automate the process, and determine net portfolio return*, I used the mf/financial goal tracker.
* To obtain the net portfolio return one take into account all past transactions to compute the average return with Excels XIRR
Two scenarios were considered
Ongoing SIPs of 1000 in each of the above funds from 3 Apr 2006.
Ongoing SIPs of 1000 in each of the above funds from 12 Jun 2009.
After 12 Jun 2009, the recovery from the 2008 crash slowed down significantly. So I wanted to test the performance in slow growth conditions.
Let us now consider each of them
Scenario I Ongoing SIPs since 3 Apr 2006
The normalised portfolio values are shown below
Note: This is the normalised value of the funds and the portfolio. This is to illustrate the volatility in the same scale. The actual portfolio value will be the sum of the individual fund values.
There are two ways to interpret this graph:
- The person who constantly chases after returns is likely to think I should have invested in Pharma, FMCG or Technology sectors!
- The person who is concerned about building a diversified portfolio in the hope of reducing its volatility to ensure steady but not a spectacular growth will be delighted.
While the portfolio volatility is indeed considerably lower than individual constituents. This is because the folio dips only when all the funds respond alike. The portfolio growth neither resembles the worst performer (UTI-infra) nor the best performers. This is the hallmark of good diversification.
Notice the reasonable downside protection during 2008 and smooth recovery.
Returns (updated 12th July 2016):
Returns (Apr 28 2014):
- UTI-infrastructure 1.74%. Total investment: 97,000; Current Value: 1,04,109
- ICICI-Pru-technology 18.26% Total investment: 97,000; Current Value: 2,06,670
- SBI-Pharma 18.65% Total investment: 97,000; Current Value: 2,10,107
- ICICI-FMCG 19.30% Total investment: 97,000; Current Value: 2,15,872
- Reliance-banking 16.15% Total investment: 97,000; Current Value: 1,89,222
- Portfolio 15.63% Total investment: 4,85,000; Current Value: 9,25,983
This is astounding because despite abysmal returns from the infra fund the net portfolio return is extremely decent for a 8 year period.
Scenario II Ongoing SIPs since 12 Jun 2009
The normalised portfolio values are shown below
Again notice the amazingly low volatility of the portfolio
Returns (updated 12th July 2016):
Again not bad at all!
Returns (Apr 28 2014):
- UTI-infrastructure 2.22% Total investment: 59,000; Current Value: 62,289
- ICICI-Pru-technology 23.44% Total investment: 59,000; Current Value: 1,03,332
- SBI-Pharma 23.99% Total investment: 59,000; Current Value: 1,04,654
- ICICI-FMCG 21.63% Total investment: 59,000; Current Value: 97,074
- Reliance-banking 11.57% Total investment: 59,000; Current Value: 7,079
- Portfolio 17.30% Total investment: 2,95,000; Current Value: 4,47,447
In this case, again infra sector disappoints. The banking fund has relatively underperformed. The net portfolio return is still an impressive 17.30%
Clearly, this method appears to be an effective way to diversify an equity portfolio.
Can we compare this with the method against the usual core-satellite diversification strategy? That is, use diversified large cap funds as core and diversified mid and small cap funds as the satellite of a portfolio.
Mr. Muthu Krishan at AIFW pointed out that Quantum Long Term Equity (see analysis here) a multi-cap fund has returned 15.5% from 2006.
So clearly, a folio well diversified across market caps delivers. However, we can only say this in hindsight. There is no way we can ensure diversification and decent returns before investing. We can only speak in hindsight about performance.
In this aspect the turn-key diversification strategy – picking different sector funds and contributing equally to them – scores. Simply by common sense. Of course, there is no guarantee that it will work. Since it is based on sound logic, combined with Rupee cost averaging, I am confident that it will.
Note: This strategy is not for getting better returns than any other strategy. The motive here is to reduce portfolio volatility, preserve gains and enhance downside protection. That such a motive will usually yield good returns is entirely incidental 🙂
I have not included any returns from diversified funds for comparison. The reason for this is hindsight bias. I can pick and choose funds which suit my argument. You can pick and choose funds which negate my argument.
Why bother? Let us agree on one thing. We can definitely get good returns with the core + satellite approach as well. However, we will have to take a chance on the competence of the fund manager and the extent of diversification
In the sector-based approach, if a sector is doing well or badly any sector fund should reflect that to a large extent. The reason for this is the portfolio has only one type of stocks (typically). So the fund managers role is less important here. Also in this approach we are guaranteed of diversification and therefore guaranteed of lower volatility.
Returns are not guaranteed, but I expect it to the comparable to the core + satellite approach if not better most of the time.
How to construct a portfolio with sector mutual funds?
The fund should be a hard-core sector fund. It should not be a sector-plus fund. That is, some funds invest in stocks outside a sector because such stocks can influence the sector. For example, some infrastructure funds invest in banking stocks.
In a sector-plus fund the fund manager plays a role. We would like to minimise his/her importance for effective diversification.
Low expense ratios would help, but this will be tough since most funds have low AUMs. Consistent performance and good risk-returns parameters as mentioned in the guide would obviously help. However, this should not vary too much among hard core sector funds.
Compare the performance of the fund with its sectoral index and not with Nifty or Sensex.
Reliance Banking practically mimics the CNX Bankex. So instead of this an ETF may be a better choice with respect to expense ratio but not with respect to liquidity! Bank ETFs have pathetic AUMs!
I had written about how these sectors are correlated with each other. I shall update the post and publish it tomorrow.
So what do you think about this method?