The Hindu Business Line : Style and sector funds: Is passive exposure optimal?

A typical core-satellite portfolio carries large-cap index funds for the equity core and active style and sector funds for the satellite portion. One of our readers asked us this question: Can satellite portfolio carry style index funds and passive sector funds?

This article explains the hierarchy of investments, ordered according to their volatility and returns process. It then explains the importance of style investing and the relevance of active management within this investment process.

Risk-free asset

To start with, the optimal investment choice is taking exposure to Treasury Bills, termed as risk-free investment. Such exposure can be taken through money market mutual funds. In the Indian context, term deposits in public-sector banks are closest to risk-free assets. Risk-free investments are the least volatile and also provide the lowest return.

The next in the hierarchy are the risky assets such as equity, bonds and alternative investments such as commodities. An investor would choose to invest in such risky assets only if she is convinced that such exposure would provide higher risk-adjusted returns. At the asset class level, such exposure can be taken through a broad-market index fund. Funds benchmarked to the S&P CNX 500 Index, for instance. Investors can choose to stop their exposure at the asset class level. But most do not. At the next level, investors can choose to take exposure to styles and sectors within each asset class.

Style benchmarks

Empirical evidence shows that returns pick-up is high at the level of style in the hierarchy of investment process. That is, a significant component of the total portfolio returns is due to investment styles.

Style refers to the common factors other than market factors that move a cluster of stocks together. Style classification is based on size and valuation and has been used extensively for constructing portfolios and building benchmarks.

Suppose an investor chooses to take exposure to mid-cap style. The optimal choice would be to take exposure to mid-cap index fund. It would, therefore, not be sub-optimal to construct the satellite portfolio with passive style and sector funds. The excess return from style over the broad asset class benchmark return (S&P CXN 500) is called misfit returns.

At the next level, an investor may take exposure to active style and sector funds if she believes that portfolio managers can generate excess returns over their benchmarks. Can they?

Active styles

According to Morningstar category returns, active style and sector funds typically generate higher returns than their benchmark index. The Birla Sun Life Mid-cap Fund, for instance, generated a three-year annualised return of 16.50 per cent against 11.50 per cent on the BSE Mid-cap Index.

While consistently generating excess returns may be difficult, the potential to do so is high, for two reasons. One, portfolio managers can overweight/underweight stocks relative to the benchmark without being unduly penalised. Typically, a conscious decision to change portfolio weights could prove costly if the fund underperforms the benchmark. Fortunately, weights of individuals stocks are very high in sector indices. ITC, for instance, has 48 per cent weight in the BSE FMCG Index. An FMCG sector fund cannot carry such concentrated exposure to any one stock. The portfolio manager is, hence, justified in changing the portfolio weight to reduce the concentration risk. And such weight drifts — whether tactical or not — can help the fund generate excess returns.

Two, style benchmarks constitute well-known as well as under-researched companies. The BSE Midcap Index, for instance, constitutes Tata Chemicals and KGN Industries. A peer universe of companies with such diverse fundamentals enables astute portfolio managers to engage in security selection to generate excess returns.

Conclusion

Passive style and sector funds fit well within a satellite portfolio. Investors can choose between ETFs and index funds for such exposure. For reasons mentioned above, taking exposure to active funds could generate higher returns. Care should be, however, taken in selecting active funds.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

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