Responsible (And Therefore Unpopular) Answers To Frequently Asked Questions From Clients - II

A few months ago I wrote an article titled Responsible (And Therefore Unpopular) Answers To Frequently Asked Questions From Clients. It essentially offered my answers to some of the most common queries I receive from my clients. But my answers are always responsible and pragmatic. They are therefore typically unpopular with most clients. The article has since received a reasonably good response. I am therefore doing a similar article today. I will be offering responsible answers to a few more common queries I receive from clients. 

Shouldn't I Be Going Beyond Large Cap Index Funds In My Equity Portfolio?

It is a well documented fact that I advocate the use of index funds for equity portfolios. I also firmly believe that large cap index funds are sufficient to offer most individuals a reasonable chance of achieving their financial goals. I am therefore largely averse to going too far beyond large cap index funds. This does not mean that it is fundamentally wrong with going beyond large cap index funds. My concerns are usually centred around how capable my clients are of dealing with the implications of doing so.

A Nifty Next 50 index fund is a very viable option for those who wish to go beyond large cap index funds. 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. There is data available to support this. The 20 year rolling return of the Nifty 50 TRI and Nifty Next 50 TRI (Total Returns Index) are 12% and 15% respectively. The corresponding figures for the rolling standard deviation of both these indices are 12% and 17% respectively. 

It is clear that the incremental expected return offered by the Nifty Next 50 comes at the cost of significantly higher risk. The incremental return of 3% over the Nifty 50 comes with a 5% increase in standard deviation relative to the Nifty 50. The Nifty Next 50 index is perfectly capable of remaining highly volatile and/or underperforming the Nifty 50 for years on end. Most investors who have entered the markets in the past 5 years are unlikely to have gone through periods of heightened volatility or underperformance that last for a few years. They are therefore unlikely to be psychologically well equipped to deal with the implications of going beyond large cap index funds. They may therefore benefit from sticking to large cap index funds until they have survived at least an entire market cycle (if not more). 

I Currently Contribute To An EPF Account. What About My Corporate NPS? 

The desire to contribute to a corporate NPS account is usually tied to two reasons. These are optimising taxes and benefiting from the employer match on contributions. But even so, a corporate NPS account may not always make sense. This is especially true where individuals are already contributing to an EPF account. The fact that EPF contributions are active typically means that corporate NPS is not a necessity. 

Also, all employers do not offer the option to contribute to a corporate NPS account. Most individuals today switch jobs multiple times over the course of a career. In the event of a job switch, the new employer may not offer the option of a corporate NPS. This would render further contributions to the corporate NPS impossible. The individual would therefore lose their benefits in terms of tax and matching contributions from the employer. 

The NPS is most tax efficient when the account is closed at age 60 or beyond. But the default age for retirement in India is increasingly tending towards 55. This means that individuals are likely to retire and need their NPS corpus well before age 60. Closing an NPS account before age 60 almost always means that 80% of the corpus would go to a taxable annuity. 

There is of course a case to be made for retiring before 60 and subsequently closing the NPS account at age 60 or beyond. But doing so would mean that the NPS is inaccessible for the first few years post retirement. It is important to remember that one's NPS corpus is mainly meant for retirement.

Pragmatically constructed financial plans would prioritise every rupee of the retirement corpus being accessible from day one in retirement. Rendering the NPS inaccessible for the first few years post retirement would therefore go against fundamental financial planning principles. 

Can I Use A Systematic Withdrawal Plan (SWP) To Structure Portfolio Withdrawals? 

A widely advocated option for structuring portfolio withdrawals is that of a Systematic Withdrawal Plan (SWP) from market linked investments. Hybrid funds are often advertised as a popular option to achieve this objective. This is because hybrid funds offer exposure to both equity and debt. But there are two major issues here. First, the equity exposure in the hybrid fund means that returns from hybrid funds would also be volatile. Second, the investor's biggest advantage in case of a Systematic Investment Plan (SIP), becomes their biggest disadvantage in case of an SWP. 

An investor doing an SIP would stand to benefit from market volatility. This is because the investor would buy more units when the markets are low, and fewer units when markets are high. This allows the investor to leverage the benefits of fundamental economic principles. But an investor doing an SWP would do the exact opposite. They would redeem more units when the markets are low and less units when the markets are high. This contravenes the fundamental principles of economics. SWPs from market linked investments are therefore not a viable strategy for portfolio withdrawals.

Withdrawals must only be made from non volatile and highly liquid products in the corpus. Savings deposits, liquid funds and money market funds therefore become ideal avenues from which to make most withdrawals from our portfolios. 

Doesn't Gold Deserve A Place In My Portfolio?

Including an additional asset class also heightens complexity when managing and rebalancing the portfolio. It is also important to note that gold as an asset class performs best during periods of economic downturns and crises. But such scenarios do not occur frequently. Under normal market conditions gold as an asset class is likely to remain muted. It would therefore do little to move the needle in terms of portfolio returns. 

It is typically advisable to allocate no more than 10% of the portfolio to gold. It would therefore add limited incremental return on a weighted average basis at the portfolio level even when it does well as an asset class. To understand how weighted average portfolio returns are calculated have a look at my earlier article Understanding Asset Classes And Their Returns The Right Way.

Why Can't I Go Beyond Liquid Funds In Debt Portfolios For Long term Goals? 

The debt component of a defensive portfolio is typically meant to mitigate credit risk and interest rate risk. To understand the meaning and dynamics of these terms have a look at my earlier article Distilling Debt Portfolio Construction. Liquid funds typically carry the least degree of credit risk and interest rate risk across all categories of debt mutual funds. It would therefore be prudent to include them in debt portfolios for long term goals. 

It is widely advocated to match the average tenure of the bonds held by a debt fund with the tenure of the goal for which it is held. For instance debt funds where the average tenure of the underlying bonds is 7 years are advocated for goals that are 7 years away. But this is not entirely true. Debt funds with a certain average tenure may hold individual bonds with a higher than average tenure. For instance a fund with an average tenure of 7 years may hold individual bonds that mature in say 10 or more years. Such bonds typically heighten volatility and risk. 

It is therefore generally prudent to hold debt funds that have average tenures that are significantly lower than the tenure of the goal for which they are held. For instance, it may be prudent to hold debt funds with average tenures of 1 year for goals that are 7 or more years away. Liquid funds therefore become prudent options for both short term and long term goals. 

Parting Thoughts 

This brings an end to another set of responsible answers to questions I commonly receive from clients. Being responsible with finances is often ridiculed until such time that there is a crisis. And when a crisis hits, what was ridiculed starts being revered. To avoid a situation where we would have no choice but to revere responsible money management, it is better to never ridicule it and imbibe it early on.