Building A Diversified MF Portfolio From Scratch

The markets have been heading southwards with Nifty 50 plummeting over 15 per cent in the past eight months. Therefore, we can safely confirm that the markets have entered into a bear zone. Moreover, even developed nations are facing the pain due to inflation and thereby aggressive hiking of policy rates. Also, experts believe that United States and the Euro Zone are on the verge of recession.If recession does happen, then more pain is anticipated. In such a scenario, most investors might be staring at a red portfolio given the fact that equity and Debt Funds are delivering negative real rate of returns.

As can be seen in the above graph, the median returns of equity mutual funds were negative 15.37 per cent, while for debt funds it was 0.88 per cent. Therefore, both the asset classes generated negative real rate of returns. Now assume that you have invested all your money in equity mutual funds. In that case, you might be staring at 15 per cent loss. However, if you had invested even in the 50:50 (50 per cent equity and 50 per cent debt) fashion, then your total portfolio would have been negative 7.24 per cent. This means that just by adding debt to your portfolio you could have cut your loss by almost 50 per cent.

Therefore, it is crucial to have a well-diversified portfolio of mutual funds. This will help you in achieving your financial goals, some of which may be your ‘needs’ and some would be ‘wants’. However, building your own portfolio is indeed a task. As iconic investor Warren Buffet once said, “We don’t have to be smarter than the rest, but we have to be more disciplined than the rest.” It is a maxim that is apt to the world of investments, which requires a more disciplined approach. Investing in mutual funds, and especially through the systematic investment plan (SIP) route, helps you to maintain that self-restraint and moderation or regimen.

Building the right mutual fund portfolio calls for a disciplined approach and proper planning. Constructing a ‘right portfolio’ may sound simple but selecting a strategy to build a right or constructive portfolio that suits you is quite complex. Hence, it is crucial on your part to identify and implement a portfolio strategy that best suits your circumstances and needs. While it is important to know the objective of your investment before deciding on your portfolio strategy, knowing your risk appetite is also equally important. This is because your risk appetite will determine your asset allocation.

There are basically two different ways of creating a mutual fund portfolio based on your situation. If you are someone who wishes to achieve his or her financial goals such as child’s education, marriage, retirement, buying a house or a car, orgoing on a vacation, etc. then here the portfolio strategy should be more conservative to moderate. However, if all these things are taken care of and you are now looking to create wealth, then a more aggressive portfolio is desired. Therefore, based on which category you belong to, choose a strategy accordingly. The portfolio strategy that we are touting about is about creating a core and satellite portfolio

Core and Satellite Portfolio Strategy
The basic principle behind the core and satellite portfolio is that the portfolio gets split into two major parts. One part of the portfolio follows the core strategy which is relatively stable and low on volatility and the other segment follows the satellite strategy, which seeks higher returns or alpha and is potentially high on volatility. So, what are the basics of the core and satellite investment strategy? The core investment strategy takes a conservative approach of investing and its main objective is to build a relatively stable portfolio. It usually goes for investment with lower risk-return profile.

Also, this strategy is passive in nature which means occasional or no re-jigging of the portfolio at all with respect to the market dynamics. Large-Cap funds, index funds, large-cap ETFs, short-term debt funds, gilt funds, etc. form part of the core portfolio. However, the percentage allocation to assets depends upon your risk appetite. This segment of the portfolio is usually directed towards achievement of your financial goals, especially those that can be identified as ‘needs’. The satellite investment strategy is sort of aggressive in nature and its main objective is to generate higher returns.

The role of a satellite portfolio is to provide investors with an opportunity to position their portfolio so that it can exploit the opportunities presented by market dynamics to get higher returns. Therefore, this strategy requires active management. The investments that are the part of this strategy are Mid-Cap funds, Small-Cap funds, thematic funds, sectoral funds, credit risk funds, dynamic bond funds, long duration funds, etc. The asset allocation would depend on your risk appetite. They are more targeted towards achievement of financial goals that are ‘wants’. This strategy is even used for wealth management.

Building a Core Portfolio
Here are some guidelines:
◘ Identify Financial Goals — A core portfolio concentrates more on your financial goals and hence it is important to identify them. You can use the ‘smart’ technique to identify and define your financial goals. It stands for specific measurable achievable relevant with time horizon.

◘ Divide between Needs and Wants —Furthermore, it is crucial to divide it between needs and wants. Doing so would help you set priorities and design the portfolio accordingly. A financial goal that is a need such as child’s education, marriage, retirement, etc. would have a more conservative portfolio approach. And a financial goal that is a want such as upgrading a car, going on a vacation, buying a new property, etc. would have a moderate portfolio approach.

◘ Assess your Risk Profile — Assessing your risk profile will help you in deciding your asset allocation. It will also help in selecting mutual funds that will suit your risk tolerance level. There are various tools available online as well as on the mutual fund companies’ websites that would help you assess your risk profile.

Portfolio based on Risk Profile

The graphs above indicate that if you move from a conservative to aggressive risk profile, the portion of equity increases and that of debt decreases. Doing so would help you to take risk that is aligned with your temperament. This would ideally be the part of your core portfolio and this would purely be a strategic asset allocation. Over a period of time your allocation tends to change due to fluctuations in the market. Strategic asset allocation periodically helps restore your original asset allocation. It is to be noted that the above portfolios are meant for long-term financial objectives. The shorter the objectives, the lower will be the equity allocation. If the investment horizon is three years or below, then it is recommended to have your money parked in safer assets.

Building a Satellite Portfolio
As opposed to the core portfolio’s strategic asset allocation, the satellite portfolio adopts tactical asset allocation. This kind of portfolio is meant purely for wealth creation. It is wise not to allocate any other financial goals with this portfolio. As it adopts tactical asset allocation, there is no constant and consistent asset allocation. The asset allocation of your satellite portfolio would change with change in valuations.

Above is the DSIJ’s proprietary equity valuation index that helps us decide on asset allocation. As can be seen, at present the markets seems to be a little below fair valuation and a 60 per cent allocation to equity and 40 per cent to debt is advisable. However, if you do not have any such sophisticated tool, then you can simply invest based on the 50-day and 200-day moving average (DMA) to make allocation decisions.

The above graph shows the movement of Nifty 50 along with its 50 DMA and 200 DMA. If you observe, when there is positive crossover of 50 DMA (red line) and 200 DMA (green line), i.e. when the 50 DMA crosses 200 DMA from below, the Nifty heads north and vice versa. Hence, when there is a positive crossover, you increase your allocation towards equity and when there is a negative crossover increase your allocation to debt. The accuracy of entry and exit points is not as good as our equity sentiment index but does help you make better asset allocation decisions. When it comes to a satellite portfolio, you mostly would be investing in a mix of mid-cap, small-cap, sectoral and thematic funds. You can also include factor investing products such as momentum, quality, value, and low volatility funds.

Portfolio in Numbers
People are always on the back of hot funds in the market, and whenever there is a new fund offer (NFO), they will rush to buy at the lower net asset value (NAV). Most often, the portfolios of these investors contain 10-15 different mutual fund schemes. This occurs as a result of a lack of planning. To keep returns in line with expectations, investors must understand the premise of diversification. It is achieved by including funds from a variety of mutual fund categories in the portfolio, which aids in the development of the portfolio’s core components. The fundamental idea behind diversification is to avoid putting all your eggs into one basket.

"A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies."

– Harry Markowitz

Investing in mutual funds, and especially through the systematic investment plan (SIP) route, helps you to maintain that self-restraint and moderation or regimen. Building the right mutual fund portfolio calls for a disciplined approach and proper planning. Constructing a ‘right portfolio’ may sound simple but selecting a strategy to build a right or constructive portfolio that suits you is quite complex. Hence, it is crucial on your part to identify and implement a portfolio strategy that best suits your circumstances and needs.

You might be aware of the fact that various securities respondto market conditions in various ways. If the equity component increases, the debt component may decrease, or vice versa. Diversification is a tool that can be used at any time to enable shock absorption to maintain the overall return of the portfolio. The stability of large-caps can be seen as a situation where a plunge in mid-caps may be shielded. It is ideal to have 5-8 mutual fund schemes spread across different debt and equity categories in your portfolio. Keep in mind that too much diversification causes lack of control, just like it does in most things in life. It is ideal to keep things simple. 

Conclusion
We believe that investment in mutual funds is futile if there is lack of a proper plan and process in place. Hence, having a mutual fund portfolio is important as it helps you to have discipline while investing. And nothing beats the core and satellite portfolio strategy in this aspect. Building your mutual fund portfolio by segregating between core and satellite portfolio helps you to avoid taking any unnecessary risks until you have covered all your important financial objectives. Moreover, such segregation also aids in lowering the impact of fall in the returns of a satellite portfolio on your financial goals.

While building a core portfolio, there are some things that you need to keep in mind, one of which is the re-balancing of your portfolio periodically. As a core portfolio adopts strategic asset allocation, over the period your allocation might be tilted more towards equity which will take the risk profile of the portfolio beyond your tolerance level. A satellite portfolio is usually used to generate those additional returns on every rupee invested. This ideally helps in capturing the best days of the market. However, while doing so, risk is also on the higher end. Therefore, having a sophisticated tool to help you in asset allocation decision is important.