Portfolio Ideas. How to reduce your investment cost

If you buy an active fund, you assume both systematic and non-systematic risk. Index funds, on the other hand, expose you to systematic risk and very little, if any, of non-systematic risk. In this article, we discuss how you can actively create a systematic risk-based portfolio.

Systematic risk refers to the risk that affects the entire market. Change in interest rate, for instance, affects all securities traded on the National Stock Exchange (NSE).

Non-systematic risk refers to risk that is specific to a company or to the sector to which the company belongs.

A change in RBI regulation, for instance, primarily affects only banking companies. Or a failure of a drug trial affects only the pharmaceutical company that is conducting the clinical trials.

Active funds have to assume non-systematic risk to beat their benchmark index.

That is, an active fund bets that a security may generate higher returns than the fund’s benchmark and, in the process, assumes greater company-specific and sector-specific risk than an index fund. You can choose to buy active funds to earn such excess positive returns. The risk is that such funds can generate excess negative returns if their bets turn wrong.

You can also aim to actively create a systematic risk-based portfolio. How? You have to create and manage a portfolio of style index funds and sector index funds. Or alternatively, you can buy style ETFs (exchange-traded funds) and sector ETFs. Style index funds are those that follow a particular investment style. Such funds, for instance, invest only in large-cap index stocks or mid-cap index stocks. Sector funds invest only in a particular sector, say, banking.

To actively create your systematic risk-based portfolio, you have to decide how much you want to invest in style funds and sector funds. Suppose you decide to broadly allocate 60 per cent to style funds and 40 per cent to sector funds. Further breaking down your allocation, you can decide to have 40 per cent (two-thirds of your style fund exposure) in large-cap style, 20 per cent in mid-cap style, 10 per cent each in banking, FMCG, pharma and technology sectors.

You have, thus, engaged in actively creating your systematic risk-based portfolio. Why? Your allocation to style fund decides how much risk you want from the large- and mid-cap spaces of the equity market.

Likewise, your allocation to sector funds decides how much risk you want to take on each sub-sector of the market. In contrast, you decide on how much of non-systematic risk to take when you buy an active fund.

You can create a systematic risk-based portfolio using style ETFs and sector index funds. This is not necessarily better than a portfolio of active funds. But this managed portfolio of index funds and ETFs reduces your investment expenses, as active funds’ expenses are twice as much, if not more.

Besides, a chunk of a fund’s return can be due to the portfolio’s systematic risk. Your actively created index portfolio tries to capture this return through low-cost investment products.

Of course, creating this portfolio requires you to decide on the allocation to style and sector funds. This is easier said than done. But then, creating a meaningful portfolio of active funds is far more complicated.

The writer is the founder of Navera Consulting. Send your queries portfolioideas@thehindu.co.in

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