Low Cost, Highly Effective Portfolios

The processes employed by Indian investors to construct their investment portfolios have evolved significantly over the years. Portfolios majorly comprising of blind purchases of almost every investment product sold to them on the back of an impressive sales pitch are becoming increasingly less common. Today's Indian investor is much more financially savvy in terms of a much more nuanced understanding of various asset classes and the role that asset allocation plays in portfolio construction and management.

But, one thing that is still lacking among most Indian investors is a proper understanding of how excessive costs and improper diversification affect their long term investment performance. The typical Indian investor usually tries to overload their portfolios with a variety of products under each asset class in the name of diversification. But beyond a point, every additional investment product that is included in the portfolio only serves to reduce the benefits of diversification rather than increase it. And if the products we include in our portfolios involve significant costs (as they usually do), it further impacts the returns generated by our portfolios adversely.

This shows that a portfolio consisting of a minimal number of products that provide broadly diversified exposure to various asset classes at the least possible cost is the most viable solution to this problem. So today, I am going to talk about the case for constructing a product light, low cost investment portfolio and how we can build one across multiple asset classes.

Holding a variety of individual securities within each asset class would require a lot more analysis and judgement on our parts as investors. Many of us may not have the time and/or competence to be able to put in the effort required effectively. Not to mention the fact that creating a portfolio of individual securities would involve a significant cost outlay that not all of us would be capable of bearing. Also in the case of certain assets such as bonds, holding them individually may come with significant tax implications for us. Mutual funds would therefore represent our best chance of building a low cost portfolio that is adequately diversified across asset classes.

Within the universe of mutual funds, a combination of a few index mutual funds and ETFs would represent the ideal route to the construction of an effective portfolio. Such funds help us preserve most of the returns we generate from them as shown in the graphic that follows.

The cost differential of - 1.8% would significantly lower our returns over longer time horizons of say 10, 15 or 20 years if we choose to invest in actively managed funds. And by extension the cost differential would work in our favour if we choose to invest in index funds by adding the amount lost to costs back to our portfolios, thereby enhancing returns. Therefore preserving as much of our returns as possible using low cost, tax efficient investment products is a much more reliable way to enhance long term portfolio returns than product selection and the employment of complex trading and investment strategies.

Constructing the equity component of our portfolio with a single large cap index fund is simplest, smartest and most efficient way to go about the exercise. A direct plan of a large cap index fund with an expense ratio of not more than 0.2% would be a viable option for our portfolios. In the Indian context almost every major mutual fund house would have one such fund available, especially for the Nifty 50. it is important to remember not to pick index funds that track anything beyond the top 100 stocks on the basis of free float market capitalisation. This is because index funds tracking anything beyond the top 100 stocks produce returns that are highly divergent from the benchmark indices that they track.

This goes against the very nature of an index fund, which is to track a major market index and produce returns that are commensurate to the index to which the fund is benchmarked. Effectively, funds that track the Nifty 50 and Nifty Next 50 are our best options when picking equity index funds. Those who wish to aim for a slightly higher risk adjusted return for their portfolios may consider building an equity portfolio with a combination of Nifty 50 and Nifty Next 50 index funds. The details of Nifty 50 and Nifty Next 50 index funds offered by some of the major mutual fund houses are given in the graphic that follows.

Constructing an equity portfolio in this way would keep costs low at around 0.2% (for an equity portfolio fully allocated to a Nifty 50 index fund) and 0.3% (for a portfolio with a 50-50 blend between Nifty 50 and Nifty Next 50), with the benefit of effective diversification that is inherent with index funds.

The exercise of constructing the debt component of our portfolios is slightly more challenging. The choice of debt products for our portfolios would depend heavily on the nature of our financial goals. It is also important to remember that the main reason for including debt products in our portfolios is to provide liquidity and stability to our portfolios. It therefore does not make sense to chase returns on the debt products in our portfolios. This is especially true for goals which are less than 7 to 10 years away, where the scope for taking on risk in assets which are relatively stable by nature is minimal at best.

Accordingly, the ideal debt product for such goals would be liquid funds and money market funds. Costs associated with liquid and money market funds on average range between 0.15% and 0.25% in case of a direct plan with the growth option. In case of long term goals which are at least 10 years or more away, there is definitely more room for taking on risk in our debt portfolios. Constant maturity government bond funds are therefore an ideal debt fund option for such goals.

Portfolio quality with such funds is very high, since such bonds represent the debt obligations of the government, whose rate of default is negligible. And because such funds adopt a passive approach to investing in government bonds, they effectively serve as a close substitute to an index fund for 10 year government bonds. Another debt fund option for long term goals would be corporate bond funds, which invest in long term bonds of fundamentally strong companies.

But while portfolio quality with such funds is quite high, the long tenure of the bonds held by these funds makes them highly sensitive to interest rate changes, resulting in more volatility and sharp falls. Costs associated with constant maturity funds and corporate bond funds range between 0.2% to 0.25% on average for a direct plan with the growth option.

All of this makes it clearly evident that it is possible to build portfolios for financial goals with a handful of low cost funds across asset classes for each goal. But this is just a broad framework beyond which there are a number of nuanced decisions that need to be made such as quantifying our financial goals, deciding the asset allocation for each goal, frequency of rebalancing, reducing the equity allocation in each portfolio as each goal comes closer to falling due and so on. Taking cognisance of these factors would allow us to fit the low cost portfolio construction framework into our financial plans, as per our bespoke financial needs. And once that happens we would be able to leverage the benefits of a diversified, low cost portfolio to the greatest extent.