Index funds have gained in popularity and acceptance all around the world with millions of investors. They are looked as a low-cost investing strategy that often delivers returns equal or better to actively managed funds. The last part is debatable. But what is not debatable is that investors leave too much on the table. In this article, I shall introduce you to a strategy where index funds can be used to deliver high risk-adjusted returns by virtue of applying two additional strategies in asset allocation and rebalancing.
What is an Index Fund?
Index funds were designed almost a half century back by John Bogle for the average Joe investor.
An Index Fund is a combination of stocks per a defined criteria or system with no active intervention. The benefits of an index fund are it’s simplicity, low expense structure and tax efficiency. The index fund works on a format that does not require an investor to take subjective decisions on portfolio type of fund manager choices.
This system worked .. and worked beautifully for the everyday investor. In the mid of 2019, money invested through index funds exceeded that invested via actively managed mutual funds in the United States.
Popularity of Index Funds
Index funds are a multi-trillion industry and one can expect them to be the preferred route of investment in other countries around the world.
There is a tons of literature and books on index mutual funds. The discipline supports the virtue of investing one’s savings in this passive investing instrument for a longish period to time. This longevity helps investors take advantage of growing prosperity in the stock markets that a brimming economy brings.
While the do-it-and-forget-it is at its core, we shall examine how index funds can be geared around a strategy that can lead to superlative risk-adjusted returns.
Strategy 1 – Improve Risk-Adjusted Portfolio Returns by Investing in Multiple Index Funds
An Index fund is a fund that invests in an index.
And an index is a combination of stocks which fulfill a certain criteria and are selected per a certain methodology with no active intervention. What is more important to understand is that an index can be broad-based or focused on a narrow segment of stocks.
Indexes are aplenty.
Here are a few from the United States –
- The Dow Jones Industrial Average (DJIA) is an index of 30 blue chip stocks of United States industrial companies. The Index includes financial services to computer majors to retailers. The Index excludes transportation and utility companies
- The NYSE Composite Index consists of all stocks listed on the New York Stock Exchange. The Index is capitalization weighted which means each stock’s contribution is proportional to it’s market capitalization
- The Nasdaq 100 Index. It tracks 100 of the largest and most actively traded non-financial domestic and international securities listed on the Nasdaq. Investors in India can invest in the Nasdaq 100 Index using the mutual fund route. The Motilal Oswal Nasdaq 100 Fund of Fund scheme invests in the Nasdaq 100 index.
In India, the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) have created a number of indices. These are utilized by mutual fund companies and other market participants. The popular ones include Sensex, Nifty 50, Nifty Next 50, S&P BSE Auto Index, Nifty Midcap 150, Nifty 500 etc.
Index funds are seeing more take-up in India. I expect over this decade to take up a higher portion of the investor’s allocation in equities.
Investor Behaviour with Index Funds
While there are multiple indices to work with, average investors tend to stick to one or or at best, two indices. This has been seen in the United States where investors have put in all savings in one or two popular index funds. These are the Fidelity 500 Index (FXAIX) or the Vanguard Total Stock Market (VTSMX).
In our bid to produce higher risk-adjusted returns, we shall examine if there is a case for using multiple indices rather a single index.
Here we take the example of the Vanguard Total Stock Market (VTSMX). This index which consists of all investable stocks in the United States (almost 4,000 stocks).
The weightages of this index are based on market capitalization of the underlying companies. A constituent like Microsoft Corporation with its $1.22 trillion market valuation takes about 3.70% of the index weight. As a result, we see that large cap companies constitute over 80% of the index. And mid caps have a much smaller 12% proportion. And finally, a few thousand small cap companies together stitch the remaining 6% weightage.
The issue with this weightage structure is that any stellar performance in mid cap and small cap stocks would be a drop in the ocean. The VTSMX index will miss out entirely on that mid cap and small cap rally. In other words, for the elephant to move, the large cap stocks will have to rise in performance to have any impact on the VTSMX.
For an investor, there are two possible strategies you can consider.
Strategy 1.1 – Invest in three separate index funds in fixed weightages and rebalance annually
This strategy requires you to not be dependent on the VTSMX index’s ever changing allocation to large, mid and small caps. Instead you can define your own weightage. So, you may want to choose 60% investment to large caps, 25% to mid caps and 15% to a small cap index. Or any other combination.
If you go with 60%:25%:15%, your fund allocation will be something like:
- 60% monies to Vanguard 500 Index (VFINX)
- 25% monies to Vanguard Midcap Index (VIMSX) and
- 15% monies to Vanguard Small Cap Index (NAESX)
Now, at the end of the year, you see that the large cap index (VFINX) has gone up. Let’s say it is now about 65% of your portfolio. And you see that the VIMSX and NAESX are unmoved. This means these will be a proportional 22% and 12% allocation to your year-end portfolio.
Need for rebalancing the portfolio
This is where you need to rebalance your portfolio. This is needed to ensure that you allocate more monies to the mid-cap and small-cap index as compared to the large-cap index. In other words, you are looking at contributing 28% of your monies to the VIMSX and 17% of your monies to the NAESX. And contribute only 55% of your fresh monies to the VFINX.
This way, you ensure that whenever you start a new year, your rebalanced portfolio always starts at a 60:25:15 ratio.
In his wonderful article, Three against one: A battle of index funds, Craig L. Israelsen has shared key statistics on this premise i.e. how using three index funds rather than one will elevate your performance using actual statistics. Israelsen shows how using a 70:20:10 allocation, you could have made a CAGR of 6.51% over an 18 year period. This is as compared to 5.89% that the VTSMX actually returned.
In the Indian context, you can look at three distinct funds to construct a similar structure –
- A Nifty 50 (available with most fund houses). OR a Nifty 50 + Nifty Next 50 (available with few fund houses). OR a Nifty 100 fund (available with some as an ETF but Axis Mutual Fund has a non-ETF)
- A Midcap 150 index fund (available with Motilal Oswal)
- A Smallcap 250 index fund (available with Motilal Oswal)
Strategy 1.2 – Invest in three separate index funds in equal weightages and rebalance annually
A second option is to offer equal weightage. That is, one-third (33.3%) of your monies to large, mid and small cap index funds. And continuing the annual rebalanced.
Continuing with the example of VTSMX v/s VFINX + VIMSX + NAESX, the study by Israelsen finds that the overall returns increases even further to 7.92% per year with this equal contribution. This is 2% higher return than the VTSMX – which is huge!
In absolute numbers, if you had invested $10,000 in the VTSMX in Jan 1999 (year 0 of study), your corpus would have accumulated $28,014 by Dec 2016. However, if you had opted for the equal weights and rebalancing option, then the same $10,000 would have grown to $39,430. That’s an incremental $11,000 over the buy-and-forget VTSMX option.
Drawback of the three funds approach
There is a drawback of this three-fund strategy that we discussed in Strategy 1.1 and Strategy 1.2. This is around the decisioning of weightages to mid-cap and small-cap indices.
There is always a fear that one might over-allocate to mid-caps and small-caps in the greed of securing higher returns. This is clearly an individual decision and it might be good to consider the ideal ratio after consulting your financial advisor.
The thumb-rule still says that if you are young (less than 40 years of age), then you can afford to have a higher allocation to mid cap and small cap indices. Someone in their 50s should have more allocation to large caps and bluechips.
Strategy 2 – Use Asset Allocation on top of Index Funds
In the previous strategy, we looked at a pure equity based asset allocation strategy. This does well in deeply developed markets like the United States. But in developing markets such as India, I recommend a strategy with additional asset nodes. This can hedge risks better and offer higher risk-adjusted returns
What is Asset Allocation?
Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.
Different assets have different levels of risk and offer different returns. Like, a short term debt based asset offers a low standard deviation (low risk) and low-to-moderate annual returns. On the contrary, small-cap equity assets are heavy on volatility but can confer potentially high returns.
The important thing here to understand is that no asset can consistently offer the highest risk-adjusted return year after year. To establish this, we looked at the annual data from 2003 to 2019. This was done for equities, debt, gold and liquid assets to understand which asset did how well in time.
On a CAGR basis, equities have returned 14.9%, gold 11.9%, debt 7.1% and liquid assets have delivered 6.9%. However, the above table shows that since 2008, gold has been the go-to asset from a returns perspective. This has been the case on more occasions than equities.
Availability of index funds across assets
We have earlier established that the Indian capital markets have different equity indices that can support an asset allocation strategy. Some index funds we can certainly look at include –
- Nifty 50 or Sensex
- Next 50
- Nifty 100
- Midcap 150
- Nifty Smallcap 250
- Nifty 500
I personally prefer the Nifty 100, Midcap 150 and Smallcap 250. These three indices covers the entire spectrum of 500 stocks in the NSE. Plus, three index funds gives me the necessary allocation for midcap and smallcap funds so that my portfolio is not rendered insignificant when there is an uptake in performance on those stocks.
The part that Indian investors are generally unaware of is that a passive investing strategy is possible in debt aswell. This is done with a constant maturity gilt fund.
A constant maturity gilt fund invests in a mix of government bonds with a maturity of around 10 years. This way, whatever be the interest rate scenario prevailing in the country, the fund’s portfolio is maintained at 10 years. This takes a passive approach towards government bond.
This construct removes the element of human predictions and the fund managers taking incorrect duration calls. It also acts as a hedge against adverse movement of future interest rates. And like most passive funds, constant maturity gilt funds are quite low on expenses.
Some of the top funds you can examine for this purpose are –
- IDFC Government Securities Fund Constant Maturity Plan – Direct Plan
- SBI Magnum Constant Maturity Fund – Direct Plan
- DSP 10Y G-Sec Fund – Direct Plan
- ICICI Prudential Constant Maturity Gilt Fund – Direct Plan
Constructing asset allocation weightages
We now have the passive funds we want to construct our diversified passive portfolio –
- Nifty 100 Index Fund (Large cap focused)
- Midcap 150 Index Fund (Mid cap focused)
- Smallcap 250 Index Fund (Small cap focused)
- Nasdaq 100 Index Fund (International focused)
- Constant 10Y Maturity Fund (Debt focused)
The next part of my study was to backtest this index data. We look at the last 14 years (01-Jan-2006 to 01-Jan-2020) to understand returns using different asset weightages.
And here is what I found.
To my suprise, the Nifty 100 and Nifty Midcap 150 were never the highest performing asset in most years. However, to their credit, they weren’t the worst performing asset aswell in these years. That “worst asset” position was shared between two very contrasting assets i.e. the Nifty Smallcap 250 and the S&P BSE India 10 Year Sovereign Bond Index.
This data is quite significant.
Most investors often don’t take asset allocation serious enough. They tend to dabble around with large caps, mid caps etc. without a strategy. This is not good because over the long run, it’s asset allocation that determines portfolio returns and risks. But amateur investors believe it is more to do with which fund or stocks one picks.
Returns across different asset classes & weightage
There can be over a million combination of weights. For better understanding I have restricted my study to three of them. These were what most investors I spoke to were comfortable having.
1. Equal weight portfolio
In an equal weight allocation, all five constituents are given a 20% weight each. On this basis, if we track performance across these 14 years, we see that a ₹10,000 investment would have grown to ₹37,600. This reaps a 9.9% annualized return.
This 20% equal weight system has performed far better returns than a couple of assets. These are the NIFTY Smallcap 250 Index (8.0% per year) and BSE India 10 Year Sovereign Bond Index (6.4% per year).
The equal weight system was also just short of the NIFTY 100 and NIFTY Midcap 150 which delivered 10.8% each.
The only index which gave superlative performance in this period was the Nasdaq 100. This international index delivered an annual return of 12.3% over these fourteen years.
In these 14 years, there were only 3 years when this equal weight allocation index gave negative returns. These were in 2008 (financial crisis), 2011 (policy confusion) and 2018 (midcaps and small caps fell).
2. Balanced investor portfolio
A balanced investor’s preference is to have a sizeable portion of assets in debt. Let’s put that at 40%.
As a consequence, we have made the allocation as follows –
- Nifty 100 Index – 30%
- Midcap 150 Index – 10%
- Smallcap 250 Index – 10%
- Nasdaq 100 Index -10%
- 10 Year Sovereign Bond Index – 40%
The investor here is clearly looking for stability. A key need is to sustain in periods where equities nose-dived with a cushion from the debt layering.
Using this high-on-debt strategy, the 14-year period grew my wealth at 9.2% annual return. Meaning, if I had invested ₹10,000 in January 2006, it would have grown to ₹34,400 over these fourteen years.
This setup is a conservative strategy but it’s utility cannot be questioned for people who abhor risk in the portfolio.
3. Aggressive investor portfolio
The aggressive investor’s allocation would have a lot more equity. I propose a 75% of his allocation to equity and the rest 25% to debt. In this regard, the weights can be –
- Nifty 100 Index – 25%
- Midcap 150 Index – 15%
- Smallcap 250 Index – 10%
- Nasdaq 100 Index – 25%
- 10 Year Sovereign Bond Index – 25%
So this investor has half of his investment in large companies in India and in the United States. This becomes the bedrock of his portfolio.
The important thing to note here is that the allocation to debt is actually more than the equal weight strategy (20%). So it is remarkable when we look back at the ₹10,000 invested in Jan 2006. I find that the money would have grown even more in this strategy (as compared to equal weight) with the corpus growing to ₹38,500 at a 10.1% annual growth rate of return.
Performance under the three strategies
Here’s a picture of how the three strategies have progressed (marked in bold lines). I have also given the performance of picking one asset and sticking with it for 14 years (thin lines)
The performance of the five asset categories and three weighted allocation strategy are –
- Nasdaq 100 Index – 12.3%
- Nifty 100 Index – returns of 10.8% per annum
- Midcap 150 Index – returns of 10.8 per annum
- Aggressive investor portfolio – 10.1%
- Equal weight portfolio – 9.9%
- Balanced investor portfolio – 9.2%
- Smallcap 250 Index – 8.0%
- 10 Year Sovereign Bond Index – 6.4%
The data reveals that putting all monies in Smallcaps and Bond alone is not a strategy which might have played out well for the investor.
This is important to understand because the Smallcap investor is deemed to be the super aggressive investor. And the bond investor is often the super conservative investor. It seems that both lost from a returns standpoint.
It was pleasing to see that the equal weight, aggressive investor, Nifty 100 and Midcap 150 investors were all within 90 bps of performance. This means either of these strategies gave the same sort of performance.
And while the Nasdaq 100 seems to have created the biggest alpha however the nature of the investment is closer to large caps which means we can have this too under the same bucket.
Strategy 3 – Using Rebalancing to Improve Portfolio Returns Performance
What is Rebalancing?
Rebalancing is the process of realigning your portfolio with the desired asset weights. Rebalancing is done by buying or selling assets in a portfolio to maintain the desired level of asset allocation that is consistent with your desired level of risk and return.
Let’s understand with a simple example.
You are keen on keeping a portfolio that has 50% of assets in equity and 50% in debt instruments. Thus, you invested ₹50,000 in equity and ₹50,000 in debt at the beginning of the year. At the end of the year, equity has grown by 15% that year while debt has grown by 8%. In other words, you now have ₹57,500 in equity and ₹54,000 in debt. This gives you a total corpus of ₹111,500.
Now this ₹111,500 has to be rebalanced or realigned to a 50:50 asset allocation. In other words, you must have ₹55,750 (i.e. ₹111,500 * 50%) in equity and ₹55,750 in debt.
As you have more in equity, you need to bring down your equity assets by selling a few. And as debt is on the lower side, you need to buy some debt assets.
- Sell Equity worth ₹1,750 (₹57,500 minus ₹55,750)
- Buy Debt worth ₹1,750 (₹55,750 minus ₹54,000)
Applying Annual Rebalancing on our Weighted Portfolios
We shall rebalance the portfolio on 1st of Jan every year to ensure that the suggested portfolio weights remain the same when we start every year. Let’s see where that takes us.
1. Equal weight portfolio
The equal weight portfolio without rebalancing delivered 9.9% per year over the 2006-2019 period.
However upon annual rebalancing, we find that the same portfolio performed much better at 11.8% annual returns.
In terms of absolute numbers if one had invested ₹10,000 on January 2006, performance within the equal weight portfolio:
- Not rebalanced – ₹37,600
- Rebalanced – ₹47,300
2. Balanced investor portfolio
The balanced investor portfolio without rebalancing delivered 9.2% per year. Upon annual rebalancing, we find that the same portfolio performed much better at 11.1% annual returns.
So if one had invested ₹10,000 on January 2006, the performance in both scenarios would be –
- Not rebalanced – ₹34,400
- Rebalanced – ₹43,500
3. Aggressive investor portfolio
The aggressive investor portfolio without rebalancing delivered 10.1% per year. And with annual rebalancing, the aggressive investor stands to make a return of 11.8% per year.
So if I had invested ₹10,000 on January 2006, the performance in both scenarios would be –
- Not rebalanced – ₹38,500
- Rebalanced – ₹47,400
Here is what we can quickly conclude from the above study –
- It is better to allocate your assets within different assets classes (like equity or debt). Or allocate to segments within an asset (like we did with large cap, mid cap etc.) to reduce your portfolio risk and attain higher risk-adjusted returns
- Use annual rebalancing to boost your portfolio returns which at the same time reduces the risk in the portfolio
I think that the first thing is you should have a strategic asset allocation mix that assumes that you don’t know what the future is going to holdRay dalio
Additional Resources You Might Like
Here are some articles you might like:
- Rakesh Jhunjhunwala and his secrets to investing (Part 1)
- Complete SIP Investment Guide (over 8000 words compedium updated until 2020)
- The trillion dollar index fund story that John Bogle started in the 1970s
- Best SIP for achieving long term goals
- 5 steps on choosing the right term insurance plan for yourself