A mutual fund portfolio should be divided into two parts - core, for stability, and satellite, for investments that have great potential but are risky. This not only reduces volatility, but also lowers the tax burden. "The premise of the core and satellite portfolio strategy is to minimise transaction costs and tax liabilities and manage volatility while looking for opportunities to out-perform the market," says Shilpi Johri, Head, Arthashastra Consulting.
65 per cent is the minimum equity exposure a mutual fund must have to qualify for tax benefits obtained from investing in equityThe core, as the name suggests, is at the backbone and must comprise 70 to 90 per cent of the portfolio. Its aim is to give stability and decent returns. Globally, index funds or passively-managed funds are the first choice for the core. An index fund replicates a benchmark index both in portfolio composition and returns. The fund manager has no say in stock selection, which eliminates the risk of wrong judgement.
The fund management costs , too, are low. Because they invest in multiple stocks, index funds are well-diversified. In India, actively-managed funds have consistently beaten benchmark indexes over the years and are likely to continue doing so. Therefore, actively managed large-cap funds can be part of the core. These funds invest in large companies and are usually less volatile than mid- and small-cap funds. The portfolio core, if it comprises such funds, will not show any sharp drop or jump in value. "Considering that in India actively-managed funds have outperformed passive funds, which is contrary to global trends, the core should ideally be built around a combination of index and large-cap funds that have a good track record and stable fund management teams," says Vishal Dhawan, Founder and Chief Financial Planner at Plan Ahead Wealth Advisors.
Equity-oriented hybrid funds can also be part of the core. These have over 65 per cent exposure to equities and 15 to 35 per cent to bonds. Since the allocation to equities is higher, the returns are in line with those from equity funds. Plus, exposure to debt gives downside protection. Gold exchange traded funds and gold funds can also be a part of the core. But they should be limited to five to 10 per cent of the overall portfolio.
The core gives stability while the satellite part of the portfolio is intended to earn above-market returns. The objective is to generate high returns through aggressive products such as mid- and small-cap funds, sector funds, thematic funds and international funds. Duration-based debt funds, which take active interest-rate bets, can also be a part of the satellite portfolio. These do not follow the hold-to-maturity strategy and instead try to profit from capital appreciation.
Such funds invest in gilt funds, income funds and floating rate funds. "Never use money from the core part to rebalance the satellite part. If the satellite part is not doing well, stick to the core portfolio," says Johri.
Periodic rebalancing - between equity and debt - is as important as creating a good portfolio. This helps investors keep up with changing market conditions. There are different ways of doing so: Fixed ratio approach: Here, exposure to equity and debt is kept at a certain ratio based on the investor's age and risk-taking ability. If this changes significantly due to market conditions, the investor shuffles the money in a pre-determined rat io. Imagine a portfolio of Rs 10 lakh with 70:30 equity-debt ratio. After a year, the equity portfolio rises by, say, 12 per cent to Rs 7.84 lakh, while the value of debt goes up by seven per cent to Rs 3.21 lakh. Clearly, the 70:30 ratio has been altered. It can be balanced by selling stocks worth Rs 10,500 and investing the money in debt.
Variable ratio approach: Here, if the value of the stock portfolio changes significantly, the equity-debt ratio shifts to a new predetermined figure. If the equity-debt ratio was 1:1 at the beginning, and the equity portfolio rises by more than 10 per cent, the investor can sell a part of the equity holding and invest it in debt to bring the ratio to, say, 4:6. Suppose a portfolio of Rs 20 lakh is perfectly balanced between equity and debt. After some time, the equity portfolio rises to Rs 11 lakh and the debt portfolio to Rs 10.6 lakh. To bring the equity-debt ratio to 4:6, the investor can sell stocks worth Rs 2.36 lakh and invest the proceeds in debt. This approach requires much greater understanding of future equity market movements.
Constant rupee value approach: Here, the value of the stock portfolio is kept constant, investing any appreciation in value in debt, or vice versa. For example, if the equity portfolio is valued at Rs 10 lakh and it rises 10 per cent to Rs 11 lakh, shares worth Rs 1 lakh can be sold and the money invested in debt. Similarly, if the portfolio value falls to Rs 9 lakh, you sell Rs 1 lakh worth of debt and invest in equities to keep the value of the stock portfolio at Rs 10 lakh.