Last Updated on September 14, 2019 at 10:39 am
This is a step by step guide on equity portfolio construction for retail investors with a listing of options available and pros and cons of each by SEBI Registered Investment Advisor Swapnil Kendhe who is part of my list of fee-only financial planners. Swapnil is a familiar name to regular readers.
Swapnil’s website is Vivektaru. You can read more about his journey here: Swapnil Kendhe’s successful transition into a SEBI RIA His approach to risk and returns are similar to mine, and I love the fact that he continually pushes himself to become better as you see from his articles:
- Becoming a competent & capable financial advisor: My journey so far
- Are you a conservative investor? Here is how you can grow your money smartly
- SEBI Registered Investment Adviser Application Process: step by step guide
- Looking for a fee-only financial planner? Here is a list of questions to ask before you sign up
- Should Mutual Fund Distributors become SEBI Registered Investment Advisors?
In the recently conducted survey of readers working with fee-only advisers, Swapnil has received excellent feedback from clients: Are clients happy with fee-only financial advisors: Survey Results. This is the first part of the equity portfolio construction guide. The second part is here: Build an equity mutual fund portfolio with these simple steps . Now over to Swapnil. I would urge investors to pay close attention to the key points of the article.
Equity portfolio construction guide 1
Many investors shun equity because of its wild fluctuations. Fixed income instruments, on the other hand, appear safe as their prices do not fluctuate. In reality, inflation makes fixed income instruments as risky (but in a different way). Equity is a proven hedge against inflation, and therefore, equity must be a part of every retail investor portfolio.
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There are three ways to invest in equity
- Directly investing in stocks
- Investing through PMS (portfolio management services)
- Investing through mutual funds
Investing in stocks
The only sensible reason to invest in stocks is to beat index fund returns over the long term. This requires good quality knowledge of stock investing and loads of time to do the research. If an investor lacks any of the two, he cannot beat the index fund return over the long term; unless he is lucky.
Many investors believe that they can purchase stock advisory services subscription and do stock investing without doing the necessary work themselves. Successful stock investing requires good stock ideas and a firm conviction in those ideas. When the ideation is not done by the investor himself, he lacks the conviction necessary to wait until stock ideas play out. This lack of conviction doesn’t let him take the benefit of quality stock ideas he may get from stock advisory services.
Stock investing is for sophisticated and disciplined investors. Hit and miss stock investing most retail investors do can lead to disastrous results. Therefore, unless the investor is willing to put time and effort required for stock investing himself, he should avoid stocks with or without an adviser. He can run a small experimental portfolio in stocks, but he must understand that the probability of his stock portfolio beating index fund return is slim.
Investing through PMS
PMSes are akin to riskier, more expensive, and less regulated mutual funds. The minimum investment requirement for PMS at present is ₹25 Lac. A SEBI committee has proposed to increase this limit to ₹50 Lac. This makes PMS unaffordable for a majority of retail investors.
Many PMS schemes charge as high as 2.5% annual management fees. If management fees are lower, there is an additional yearly fee in the form of profit-sharing above a threshold return. Profit-sharing could be as high as 20% of the gains if returns are over 10% in a year.
PMS fund managers try to generate higher returns than equity mutual funds post expenses. Since expenses in PMS are higher than mutual funds, they use riskier strategies like running concentrated portfolios or heavily investing in micro-cap or small-cap stocks. While these increases the probability of higher returns, it also increases the likelihood of terrible underperformance.
The publicly available data about PMS schemes is of poor quality and unreliable. This makes selecting quality PMS fund managers more difficult than selecting good mutual fund managers. Because of these inherent difficulties in PMS investing, it is better to restrict exposure of PMS up to 20% of the overall equity portfolio. Investors should ideally pick 3 to 4 different PMS schemes and invest in them equally to reduce fund manager risk. Investors can do this only if the equity portfolio size is over five crores. This makes the PMS unviable option for most retail investors. Equity mutual fund is, therefore, a more sensible option for retail investors to invest in equity.
Investing through mutual funds
There are three ways in which retail investors can design their equity mutual fund portfolios
- Using actively managed funds
- Using Index Funds
- Combination of the two
Actively managed equity mutual funds
Before understanding different categories of actively managed equity mutual funds, one must understand how SEBI differentiates largecap, midcap and smallcap.
Definition of largecap, midcap & smallcap
– Largecap: First 100 companies in terms of full market capitalisation
– Midcap: 101 to 250 companies in terms of entire market capitalisation
– Smallcap: 251 company onwards in terms of full market capitalisation
Total market capitalisation is the current price of stock multiplied by the total number of shares of the company.
Categories of actively managed equity mutual fund schemes
– Largecap: At least 80% in largecap
– Midcap: At least 65% in midcap
– Smallcap: At least 65% in smallcap
– Large & midcap: At least 35% each in largecap and midcap
– Multicap: At least 65% in equities and no market-cap wise restriction
– Sectoral/Thematic: At least 80% in the chosen sector stocks
– Focused: At least 65% in equities and a maximum of 30 stocks in the portfolio.
– Dividend Yield: At least 65% in equities but in dividend-yielding stocks
– Value/Contra: At least 65% in equities, the scheme should follow value or contra investment strategy.
– ELSS: At least 80% in equities, lock-in of 3 years and tax benefit under section 80C
Most suitable category of actively managed equity funds for retail investors
Retail investors who lack interest, inclination or time required for investing should aim to create a portfolio that can run on autopilot and doesn’t require frequent monitoring and changes.
If we use categories like largecap, midcap, smallcap or sector funds, we need to decide the allocation within each category of funds. This allocation should ideally be managed dynamically. There are times in the market when midcap or small cap becomes expensive, and its allocation requires to be reduced. Likewise, there are times when midcap, smallcap or different sectors offer a better risk-reward ratio compared to large cap, and their allocation in the portfolio can be increased. It is difficult for retail investors to manage such allocation dynamically. Therefore, the most suitable category for them is multicap.
In the multicap category, the allocation decision is left to the fund manager who is better equipped to take allocation decision compared to retail investors and their advisers. The fund manager doesn’t have a restricted mandate, and therefore, he is free to invest where he finds better opportunities.
At times investors complain that the multicap fund portfolio looks like a large cap fund, but this should not be a reason to complain. Multicap category doesn’t mean that the fund manager should invest across market capitalisation. If he believes that large cap offers better risk-reward ratio than midcap or smallcap, he is free to keep most of his portfolio in large cap. Investors should avoid judging fund manager decisions unless they understand stock investing as much as the fund manager; in which case they are better off investing directly in stocks.
Another advantage of multicap category funds is that these funds are mostly managed by chief investment officer (CIO). Usually, the best and the most experienced fund manager in a fund house is CIO. Therefore, in multicap funds, investors get access to the best fund manager of the fund house by default.
The equity part of aggressive hybrid equity funds is managed like multicap funds. Therefore, these funds can also be used instead of multicap funds. But to take the same equity allocation in the portfolio, 1.5 times the amount of pure equity funds needs to be invested in aggressive hybrid equity funds, since the equity allocation in hybrid equity funds is 65% to 70%.
How many funds to hold in a portfolio?
No matter how experienced a fund manager is and how well he performed in the past, some uncertainty is always there about his future performance. Luck also plays a significant role in a fund manager’s performance.
If we use a single fund in the portfolio, we significantly expose ourselves to potential mistakes, negligence, or incompetence of the fund manager. It is, therefore, safer to divide actively managed equity portfolio equally among three to four different fund managers to reduce exposure to the fund manager risk in the portfolio.
Finding best performing funds of the future
Many investors expect their advisers to find the best performing funds of the future. Let us see what an adviser must do to find such funds.
The adviser must first list down all the equity funds and fund managers managing these funds today. He also needs to list down all the fund managers who will manage these funds in the future. Now he must predict the behaviour of all these fund managers in the future in a system which itself is unpredictable. No human being can do this. If anybody claims to do this job, either he has an illusion of understanding, or he is a salesman.
Fund selection
Most investors believe that it is possible to select better performing funds of the future based on past performance. They go to fund comparison websites, check one, three or five-year performance and typically choose funds that generated the highest return in the recent past. Star ratings of such funds are also high, which gives them added comfort. But funds so selected soon disappoint investors and underperform either their peers or the benchmark. Investors repeat the same process to choose a new fund to replace the old fund, which again results in disappointment.
Mature investors understand that one, three or five-year fund performance data is too inadequate to draw any inference about the fund, and therefore they look for more extended data. They also use sophisticated tools for fund selection. This approach certainly helps avoid bad funds, but it only marginally does a better job of selecting better performing funds of the future. In fact funds so selected are as likely to underperform as those selected with superficial techniques. Fund performances can quickly change in either direction, and all the analysis can go for a toss in no time. No amount of study and past performance data gives the proof of certainty that fund’s performance will be as good in the future.
Why a fund’s past records cannot predict future returns? Jim O’shaughnessy partly answers this question in his book ‘What works on Wall Street’
“Most traditional manager’s record cannot predict future returns because their behaviour is inconsistent. You cannot make forecasts based on inconsistent behaviour, because when you behave inconsistently, you are unpredictable. Even if a manager is a perfectly consistent investor, a hallmark of the best money managers-if that manager leaves the fund, all predictive ability from the past performance is lost.
Moreover, if a manager changes his or her style, all predictive ability from the past performance is also lost. Traditional academics, therefore, have been measuring the wrong things. They assume perfect, rational behaviour in a capricious environment ruled by greed, hope, and fear. They have been contrasting the return of passively held portfolio- the index- with the returns of the portfolio managed in an inconsistent, shoot from the hip style. Track records are worthless unless you know what strategy the manager uses and if it is still being used.”
Here is Daniel Kahneman in his book ‘Thinking, Fast and Slow.’
“Mutual funds are run by highly experienced and hardworking professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than fifty years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than playing poker. More importantly, the year to year correlation between the outcomes of mutual funds is very small, barely higher than zero. The successful funds in any given year are mostly lucky; they have a good roll of dice. There is general agreement among researchers that nearly all stock pickers, whether they know it or not-and few of them do-are playing a game of chance.”
Past data tells a lot less than most investors and advisers think it does. Market conditions change, fund managers change, fund strategies change (majorly because of an increase in the fund size). These changes eliminate any link between the past and future, making past performance data irrelevant. An adviser’s analysis of past data can give him an air of being a competent adviser, but it gives him little advantage over others who select funds based on the star rating.
There are no reliable tools or strategies that can help us select, in advance, funds that will outperform peers and benchmark based on past performance. Even if there are, retail investors and most advisers with their limited resources and understanding of investing cannot use them successfully.
The second part is here Build an equity mutual fund portfolio with these simple steps If you find the article useful, do share it. If you wish to work with Swapnil, you can contact him via Vivektaru.
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