Index funds have gained in popularity and acceptance all around the world with millions of investors. Tons of literature surrounding index funds supports the virtue of investing one’s savings in this passive investing instrument for a longish period to time (mostly retirement) and take advantage of the prosperity in stock markets that a growing economy brings. let it grow with time as the country’s economy develops. And while there was never a strategy that was brought forward for the masses, we shall examine in this post how index funds can be geared around a strategy that can lead to superlative risk-adjusted returns to your investment portfolio
Index funds were designed almost a half century back for the average Joe investor. The USP of this financial product was it’s simplicity, low expense structure, tax efficiency and a format that did not require the investor to take subjective decisions on portfolio type of fund manager choices. This worked – and in the mid of 2019, money invested through index funds exceeded that invested via actively managed mutual funds in the United States.
For a detailed overview of how index funds became a multi-trillion industry, do read my post titled $4 Trillion & Rising – The Index Funds Story in 2020.
Strategy 1 – Improve your Risk-Adjusted Portfolio Returns by Investing in Multiple Indices rather than a Single Index
An Index fund is a fund that invests in an index. And an index is a combination of stocks who 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 industrial companies in the United States. The Index includes financial services to computer majors to retailers but 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 proportion in the index is proportionate to it’s market capitalization
- The Nasdaq 100 Index 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 by investing via the Motilal Oswal Nasdaq 100 Fund of Fund scheme.
In India, the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) too have created a number of indices in India for mutual fund companies and other market participants to utilize. These include popular ones like the 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 and I expect over this decade to take up a higher portion of the investor’s allocation in equities.
While there are multiple indices to work with, average investors tend to stick to one index 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 like 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 as compared to putting all monies into one single index.
Here we take the example of the Vanguard Total Stock Market (VTSMX) index which consists of all investable stocks in the United States – which is almost 4,000 stocks. Since the weightages are based on market capitalization of the underlying companies, a constituent of the index 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 with mid caps having a 12% proportion and a few thousand small cap companies having just a 6% overall weightage.
The issue with this weightage structure is that any stellar performance in mid cap and small cap stocks in the United States would be a drop in the ocean in the performance of VTSMX and this 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 more information about Nifty 50, do read the article on : List of NIFTY 50 Stocks with Sector & Market Cap Info
For an investor, there are two possible strategies you can consider.
Strategy 1.1 – Invest in three separate 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 but to define your own weightage. For example – you make want to choose 60% investment to large caps, 25% to mid caps and 15% to a small cap index.
In this case, at the beginning you would put –
- 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 and is now about 65% of your portfolio while the VIMSX and NAESX are unmoved at a proportional 22% and 12% contribution to your year-end portfolio.
This is where you need to rebalance your portfolio 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 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 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 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 funds in equal weightages and rebalance annually
A second option is to offer equal weightage i.e. 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 – which is more than 2% higher return than the VTSMX.
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 – which is over $11,000 more than the buy-and-forget VTSMX option.
One drawback of this three-fund strategy that we discussed in Strategy 1.1 and Strategy 1.2 might be the decisioning around the weightage 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 for you to consider the ideal ratio after consulting your financial advisor. The thumbrule still says that if you are young (less than 40 years of age), then you can afford to have a higher allocation to midcap and smallcap indices when compared to someone in their 50s.
Strategy 2 – Use Asset Allocation on top of a Passive Investing Strategy that includes Domestic Equities, International Equities and Bonds
In the previous strategy, we looked at a pure equity based asset allocation strategy which does well in deeply developed markets like the United States but in developing markets such as India, I recommend a strategy that envelopes around additional asset nodes that can hedge risks better and offer higher risk-adjusted returns
How Important 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. For example – a short term or high quality accrual debt based asset offers a low standard deviation (low risk) however also offers low-to-moderate annual returns. On the contrary, small-cap equity assets are heavy on the volatility angle but can confer potentially high returns.
The most important point here to understand that no asset can consistently offer the highest risk-adjusted return year after year and that different best performing assets show up each year. To establish this, we looked at the annual data from 2003 to 2019 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 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
- Nifty Next 50
- Nifty 100
- Nifty Midcap 150
- Nifty Smallcap 250
- Nifty 500
I personally prefer the Nifty 100, Midcap 150 and Smallcap 250 as it covers the entire spectrum of 500 stocks in the NSE but unlike the VSTMX example we used earlier in this post, three index funds gives me the necessary allocation I would like 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 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 thus taking a passive approach towards government bond. This construct removes the element of human predictions and the fund managers taking incorrect duration calls or on the 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)
- Nifty Midcap 150 Index Fund (Mid cap focused)
- Nifty 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 over the last 14 years (01-Jan-2006 to 01-Jan-2020) to understand how returns will look upon using different weightages of assets. 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 but to their credit, they weren’t the worst performing asset aswell in these years. That position was shared between two very contrasting assets – 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 and tend to dabble around with large caps, mid caps etc. without a strategy. This is not good because over the long run, it is asset allocation that determines portfolio returns and risks rather than which fund or stock one picks as the data has proven that there is bound to be ups and downs.
Returns across different weightages
While there can be a million combination of weights, for better understanding I have restricted my study to three of them that most investors I spoke to were comfortable having.
1. Equal weight portfolio
In an equal weight allocation, all five constituents (NIfty 100, Midcap 150, Smallcap 250, Nasdaq 100 and Constant 10Y Maturity Fund are given a 20% weight each). On this basis, if we track performance across these 14 years, we would see that a ₹10,000 investment would have grown to ₹37,600 entailing 9.9% annualized return.
This 20% equal weight system would have far better returns than the NIFTY Smallcap 250 Index (8.0% per year) and BSE India 10 Year Sovereign Bond Index (6.4% per year) and would have been 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 which has delivered an annual return of 12.3% over these fourteen years.
We further find that in these 14 years, there were only 3 years when this equal weight allocation index gave negative returns (2008, 2011 and 2018).
2. Balanced investor portfolio
A balanced investor’s preference is to have a decent portion of the assets in debt which we reckon is about 40%. As a consequence, we have made the allocation as follows –
- Nifty 100 Index – 30%
- Nifty Midcap 150 Index – 10%
- Nifty Smallcap 250 Index – 10%
- Nasdaq 100 Index -10%
- 10 Year Sovereign Bond Index – 40%
The investor here is clearly looking for stability and to sustain the periods where equities nose-dived but the debt layering provided the investor with good cushion. Here we find that the 14-year period grew my wealth at a 9.2% annual return which means 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 75% of his allocation to equity and the rest 25% to debt. In this regard, the weights will be –
- Nifty 100 Index – 25%
- Nifty Midcap 150 Index – 15%
- Nifty Smallcap 250 Index – 10%
- Nasdaq 100 Index – 25%
- 10 Year Sovereign Bond Index – 25%
So this user has half of his investment triggered around large companies in India and in the United States which 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 however when we look back at the ₹10,000 invested in Jan 2006, we find that the money would have grown even more in this strategy with the corpus growing to ₹38,500 at a 10.1% annual growth rate of return.
Here’s a picture of how the three strategies have progressed (bold lines) as compared to simply having picked up one asset and sticking with it for 14 years.
The performance of the five asset categories and three weighted allocation strategy are –
- Nifty 100 Index – returns of 10.8% per annum
- Nifty Midcap 150 Index – returns of 10.8 per annum
- Nifty Smallcap 250 Index – 8.0%
- Nasdaq 100 Index – 12.3%
- 10 Year Sovereign Bond Index – 6.4%
- Equal weight portfolio – 9.9%
- Balanced investor portfolio – 9.2%
- Aggressive investor portfolio – 10.1%
The data reveals that putting all monies in Smallcaps and Bond Index is not a strategy which might have played out. This is important to understand because the Smallcap investor is deemed to be the super aggressive investor while 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 and Nifty 100 and Midcap 150 investors were all within 90 bps of performance which 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, when you do your annual rebalancing exercise, you see that 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 which gives you a total corpus of ₹111,500.
Now this ₹111,500 has to be rebalanced or realigned to a 50:50 asset allocation which means 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. Quantitatively –
- 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
Under annual rebalancing, 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, here is how the performance would have been in both approaches 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 but 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 conclude from the above study –
- It is better to allocate your assets within different assets classes (like equity or debt) OR allocated 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