The Hindu Business Line : Beta exposure: Is direct investment better than index funds?

Readers may be aware of the core-satellite approach to portfolio management. This involves constructing a core portfolio for the beta (market) exposure and a satellite portfolio for the alpha (excess) returns. There were couple of interesting questions that we recently addressed for an investor who wanted to structure such a portfolio. The investor’s questions were two-fold. One, can the core portfolio be constructed through direct investments instead of with index funds? Better still, can it be constructed with index futures? And two, how should an investor manage the portfolio, resisting the temptation to move stocks between the core and the satellite portfolio?

We address these issues, showing why index funds are a better choice for the beta exposure. We also suggest how investors can set-up a system that will enable them to resist the desire to move stocks between the core and the satellite portfolio.

Constructing core portfolio

The objective of a core portfolio is to have long-term exposure to equity. This portfolio is expected to generate only beta returns — returns that compensate for the market risk.

Index funds offer low-cost beta exposure. Importantly, such funds help investors moderate the regret aversion bias. This is the emotional bias that paralyses an investor from taking an investment decision because of the fear that the decision may go wrong at a later date.

Suppose the market tanks after an investor buys 10 large-cap stocks. The investor will suffer regret even if the stocks are part of the long-term holdings. A systematic investment plan (SIP) set up to buy large-cap index fund moderates this bias, as it helps investors take exposure at various price levels.

This does not mean that investors should not take direct exposure in large-cap stocks. That requires large capital outlay. The investment objective can still be served by selecting few stocks that can mirror the index returns. Statistical models can be used to construct such a portfolio. But why take such exposure when index funds serve the purpose well?

Taking beta exposure through Nifty futures has its own merits. For one, futures contract also offers a low-cost beta exposure. For another, futures contract requires lower capital than that of index funds for the same level of exposure. This frees capital that the investor can use to take higher exposure in the satellite portfolio.

There are, however, two factors to reckon with. The margin requirement in a futures contract injects more variability into cash flows. Besides, the position will be continually exposed to rollover risk. This is the risk of shifting the futures position from the current month to the next at a higher price.

Core-satellite separation

Take a retail investor whose asset size is Rs 15 lakh. Suppose the investor decides to take exposure of Rs 10 lakh in the core portfolio and Rs 5 lakh in the satellite portfolio.

Constructing a core-satellite portfolio through direct exposure in the equity market is one task. To manage such a portfolio within the investment framework is quite another. The problem comes from the fact that most investors overtrade.

The urge to overtrade could sometimes leads to asset allocation that is largely different from the strategic asset allocation policy set out in the investment policy statement. This arises because investors gradually begin to trade on their core portfolio as well.

To overcome this urge to shift stocks, investors can open two separate broking accounts , preferably with two different brokers. One account has to be strictly used for core portfolio, and the other, for satellite. This system will minimize the urge to move stocks between the core and the satellite portfolio.

Moving stocks from core to satellite portfolio typically happens when the investor wants to take profits on large caps because the stocks in the satellite portfolio are not generating enough returns. Moving stocks from satellite to core portfolio typically occurs when unrealised losses in certain stocks in the satellite portfolio are so high that the investor decides to convert them into long-term holdings!

It is important to note that the core and satellite portfolio can both separately hold the same stock. The process of having two separate accounts forces the investor to make conscious switching decisions. And that is more difficult to make than the mindless switching that happens when core and satellite portfolio sit in the same account.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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