Investors spend a lot of time and money picking individual stocks, while they spend relatively little deciding what types of equity or bond funds to add to their portfolio. It should be just the opposite.
Asset allocation process has a few pre-requisites: clarity on risk, potential for returns and a number of asset classes which have diverse risk-return profiles so that all the portfolio does not move together.
The first step in asset allocation is to determine the kind of instruments to be used: use the base security i.e. stock (shares) for equity, bonds, physical gold/ silver, bonds etc. or use derivatives i.e. futures, or options or use mutual funds or index funds/ETFs based on benchmark indices. Direct investment in stocks or derivatives requires a high degree of sophistication and carries a higher level of risk. Additionally, leverage can multiply losses. Using actively managed mutual funds requires a fair amount of sophistication and luck to be able to identify and switch into the right funds/ managers.
One of the huge advantages with ETFs is exposure to many asset classes that were hitherto unavailable or extremely costly e.g. gold, international/emerging market equities or mid- or small-cap equities. Relative index risk characteristics versus individual stocks or active funds make indices compelling:
Wide market access within a specific asset class/sector. For example, Nifty offers exposure to less than 50% of the market, CNX Midcap Index represents 15% of the NSE market capitalisation. Indices offer exposure to multiple industries (except sector indices), lowering their volatility as compared to stocks, and improving returns over longer periods.
The CNX Midcap index has a lower beta and standard deviation even than Nifty, let alone individual midcap stocks.
Index funds are low cost as turnover and management fee is low. A 1% p.a. savings on the expenses can add significantly to returns – based on the 17% CAGR returns from Nifty in the past 10 years (2001-2010) period, a 1% savings in costs would have generated an additional return of 42% over the same 10 years. The investor knows the holdings at all times, something which you do not get with traditional mutual funds. ETFs offer further advantages namely realtime liquidity as they act like a fund, trade like a share.
An asset allocation strategy using ETFs requires creating a core portfolio of ETFs, wrapping it with peripheral ETFs and creating an optimal mix. While 'buying and holding' the market offers the best risk-adjusted returns, some asset classes do offer better returns. Choose such asset classes as 'peripherals', with low correlation to the 'core portfolio'
The rule of thumb for core portfolio is one that offers a wide, non-specialised exposure to the respective asset class such as domestic broad market equities, government and private bonds, commodities (e.g. gold) and cash and cash equivalent/ money market assets.
A large-cap equity ETF, a midcap equity ETF, a medium duration bond ETF, Gold ETF & other commodity ETFs can be used to create the exposure. All of these should be studied for their history, underlying index constituents and risk characteristics.
Portfolios require additional elements which have growth characteristics along with a distinctly low correlation to the core portfolio.
For example, international equity (say Nasdaq-100 or Emerging Market ETFs), style exposures (say niche small cap or growth/value ETFs) and sector ETFs (such as Banking).
These specialised investments assist the core portfolio with further diversification (low correlation), reduced overlap and potentially enhanced risk-return characteristic. Some of these ETFs are still relatively new or unavailable in the Indian market but the product variety is expanding rapidly.
Finally, discipline in investing is the key to a successful asset allocation. Two parts of that discipline is to hold true to allocating assets to core and peripheral and periodic rebalancing.
Rebalancing periodically and when preset allocation thresholds are triggered, will keep the portfolio risk at a manageable level while booking profits.