Investment Objectives & Advice

Efficient Frontier & Asset Allocation!

Couple of weeks back, i wrote about how do i select a fund for my portfolio. That has got quite a few review/ feedback, though few people also requested to share my approach on asset allocation. Today I am trying to put together my thought process, The real process is more or less meet these steps in principal for long term goals (5yrs & beyond). You might find this tedious but this is typically a once in few years exercise and If you find it tedious than stick with typical simplified thumb rules (I will summarize it in the end).

I typically segregate my portfolio in two sections, first which holds risky assets like equity & gold and second which has debt investments.

Step 1: The selection of equity funds was covered in detail in the last article (Please read: Link). I analyse the list of potential funds with there risk & return profile and then pick the fund which has a better return per unit of risk. This process can also be called as formation of Efficient Frontier. This is the line of selected funds in a manner that each fund has the best return for the same unit of risk. The funds which are not on the Efficient Frontier like ICICI Pru Bluechip or SBI Large & Mid cap etc are not considered. Based on my risk profile, I pick one fund from the funds on this frontier line.

Efficient Frontier

Step 2: There is an advantage of adding gold with equity funds which does reduces the volatility of the portfolio given the -ve correlation between gold and equity.  This was reflected in the earlier articles Gold: to buy or not to buy! & Modern Portfolio Theory I personally like to keep (10% – 20%) of risky asset portfolio in gold depending on the valuation cycle of equities. You can see from the below chart that portfolio 3 outperforms most of the time with lowest risk among portfolios. I personally prefer the Portfolio 2 which has similar return profile but slightly higher risk. The main reason to do so is that a good multi-cap fund mostly will have 60-30-10 split between Large cap, Mid-cap and Small cap. Instead of me looking for 3 different funds.

Portfolio 2 = Gold 10%, Large cap 54%, Midcap 27% and Small Cap 9%

Gold & Equity

Step 3: The last step is to decide the split between the risky assets and risk free assets. Risk free assets are your fixed deposits, EPF, PPF etc where the returns are fixed and not highly volatile. Debt funds does carry various risks like counter party risk, interest rate risk etc. (Read: How to build your debt portfolio.) The mix of debt investments is to reduce risk in your investments. Let’s see the possible range of returns i expect at the various portfolio mix.

Portfolio Returns_V1

So even if you are defensive investor, you should keep at least 10% investment in Eq+Gold and if you are a super aggressive investor, still i would suggest to keep 20% of your investments in the Debt instruments. I personally hop between three asset allocations 80% Debt/ 50% debt or 30% debt and rest in equity + gold based on Valuation Index. I have been in the 80-20 split for last 2 years and now moving towards 50-50 split, The last 10yrs CAGR of the portfolio is still >10% including the double digit returns in FY 19-20 even after the recent drop in equity markets.

Now, I can understand that doing all these things together can be too complicated for a simple investor. What is the simplified approach? A portfolio like below is widely suggested and it has its merit of being moderate in approach as well as can be suggested to a wider population. Follow a 60 : 40 Portfolio and keep re-balancing it half yearly, you will outperform most of the portfolios.

Asset Allocation

Please note that most of these analysis are on the past returns/ historical data so there is no guarantee of similar return profile in future. As i mentioned, I personally follow Dynamic Asset allocation mostly for the risk management and engagement in managing my portfolio. let me know if this was helpful, looking forward to your comments/ feedback. 

Happy Investing!



Mutual Fund

HDFC Hybrid Equity: Tough to replace

Over the last 3-4 years, I have simplified my portfolio and finally had only one equity fund in my core portfolio “HDFC Hybrid Eq Fund”. The exposure to this fund was pretty high and so were the losses in the recent fall. The losses were so tempting (yes tempting) that if i sell my holding, I could make my capital gains tax in the current FY to “0”. I had two options:

  1. Sell my current equity fund and then buy the same
  2. Sell my current equity fund and then buy a better available fund

Obviously, I didn’t want to cut my exposure to equity but increase it. I am sharing here my approach and analysis i did on historic data to pick the fund for Core portfolio. I decided to explore Option 2 because i knew, if i wont change the fund now then i might not change it for another 4-5 years due to lethargy. Also, This was one of the valid reasons to sell your funds.

Should i replace it with an Index fund?

I am sure, you would have heard the benefits of index funds. Lot of articles claim that the index funds are a good starting point including the “Mutual Fund Sahi Hai” campaign suggests Index fund as a starting point. Those who don’t know about index fund: “Index funds are passive funds, The mandate of Portfolio Manager is only to keep the holdings of various stocks in mirror fashion to the Index it is tracking. Two main indexes in India are NIFTY 50 or BSE SENSEX.” The usual benefit touted for index funds are lower expense ratios and no large under-performance vs the actual index. This was tempting and i thought to explore it. I picked the HDFC Index Nifty 50 fund, it has the long available history since the start of 2002 to compare with HDFC Hybrid Equity Fund.

Approach: I took the daily NAVs for both the funds since the start of Jul 17, 2002 to Mar 25, 2020. Calculated the rolling returns on a 5 yr basis for all possible 5 yr periods starting (for e.g. Jul 17, 2002 to Jul 16, 2007). I have also calculated the maximum draw downs for each of these 5 year period.

Results of Return Profile: There were 3000+ such rolling returns so to compare the results, i used the parameters like Geometric Mean of observations, Median of all observations, Minimum returns and Maximum returns. You will notice the out-performance of HDFC Hybrid Equity over the HDFC Index Nifty 50 fund. Though i might have to sacrifice some upside if it is going to be a bull market because the maximum possible return in historic data for HDFC Index Nifty 50 is higher vs the HDFC Hybrid Eq.

HDFC index vs HDFC Hybrid

Results of Risk Profile: Some people will come back with the explanation that the out-performance is due to higher risk. So i also, looked into the risk profile using parameters like Standard deviation, max draw downs (MDD). I have calculated the MDD for each 5 yr time period to compare the lowest MDD or highest MDD among these 3000+ data points. You will notice the HDFC Hybrid Equity outperforms HDFC Index Nifty 50 on the Risk profile as well.

HDFC index vs HDFC Hybrid Risk

The last argument (which i also agree to an extent) is that as India market becomes more mature, Outperforming the index will be a challenge for active funds. Therefore, I looked at the history of these 5 yr returns to see the extent of out-performance (HDFC Hybrid Eq – HDFC Index Nifty 50). You will notice that HDFC Hybrid equity lagged the index returns in the initial phase, Then it continue to outperform for almost 10yrs.

HDFC index vs HDFC Hybrid Outperformance

The extent of out-performance has been deteriorating. Though it is still an out-performance with a lower MDD as well as volatility. Since, the data still points out that having an active fund is a better option, I ditched the Index fund again for couple of years.

Which Category of Active Fund should I Opt for?

This is another challenge that if i have to pick an active fund, Which category i should look for? In an article couple of years back, I highlighted the basics about how to build the Core & Satellite Portfolio. Over last year, I have also reviewed all the main categories of equity fund Aggressive Hybrid, Large Cap, Large & Mid Cap, Multi-cap etc, This has helped me get the foundation ready. Below is the approach i followed.

Approach: Let me start by saying that I did not consider Mid-cap funds for Core Portfolio as they are more risky & volatile and Small Cap funds are not for me. My heart was to move towards Kotak Standard Multi-cap fund after all they have ~30,000 Cr Assets under management in one fund. I picked the funds history from the start Sep 11, 2009  to Mar 18, 2020 and also compared it with the two best funds in each of the 4 categories which already reached by considering parameters like expense ratio/ turnover, AUM, Upside/Downside capture ratios etc. If the funds were started after Sep 2009, I did not considered them in the analysis. Here are the funds i compared against each other:

  1. Hybrid Aggressive: ICICI Pru Eq & Debt Fund/ HDFC Hybrid Eq
  2. Large Cap: ICICI Pru Bluechip/ Nippon Large Cap
  3. Large & Mid Cap: SBI Large & Mid Cap/ Canara Robeco Emerging Equities
  4. Multi-cap: Kotak Standard Multi-cap/ SBI Magnum Multicap
  5. Nifty Index 100 TRI (I don’t want to under-perform the Index so have to keep one Index)

Results of Return Profile: There were 1300+ such rolling returns so to compare the results, i used the same parameters Geometric Mean of observations, Median of all observations, Minimum returns and Maximum returns. You will notice that all of these funds have beaten the Nifty 100 TRI Index. This helped me build my confidence to stick with an active fund. Except Canara Robeco Emerging Equities, funds were having mean returns in range of 14-17% and it is also important to understand if the risk of these funds are quite different or same.

Core Funds Return

Results of Risk Profile: I looked into the risk profile using parameters like Standard deviation, max draw downs (MDD) in similar manner.

Core Funds Risk

To make it easier for to visualize, i used the Risk vs Return chart for these funds, as below. You can now see that Canara Robeco was definitely most volatile in the lot, though its out-performance across funds were also astounding, For this fund, the volatility is an imperfect metrics because the lowest return (5.3%) for it was also the highest and so was the max return (35.3%).

Core Funds Risk vs Return

There are only two funds which had lower risk vs HDFC Hybrid Eq, Though the returns of ICICI Pru Bluechip are lower vs HDFC Hybrid Eq so it is not worth considering. If i agree to take more risk, I should ask for higher returns and Kotak Standard Multi-cap does meet that criteria. After this exercise, I came to below possibilities:

  1. Reduce risk with similar returns: ICICI Pru Eq & Debt
  2. Take More risk & more returns: Kotak Standard Multi-cap or Canara Robeco Emerging Equities

As of today, I finally moved out of HDFC Hybrid Eq completely after an association of 10yrs+ and replaced it with one of these funds. The analysis here is not authoritative and obviously do not promise me future returns. It also do not cater to things like change in mandate or Fund manager etc etc. Though this gives me the peace of mind, That i am making a decision based on my analysis and understanding and it did help me improve my understanding of the investment options. Hope, i will be again in for long haul with >10yrs this time.

Happy Investing!!