How to design your portfolio?

The investment decision process for retail investors has been well-documented by professionals and academia.  The process can be described as follows:

1. Setting the long-term asset allocations (for example, how much into bond and how much into stock)

2. Establish the investment policy and rebalancing parameters

3. Determine between active and passive allocation

4. Selecting the funds

5. Continuous monitoring and rebalancing

The activity listed above should be followed in the above sequence as the first two points hold utmost importance. They are also relatively inexpensive and many a time, tax-efficient. There are ample researches, which show that the first two activity accounts for most of your long-term return of the portfolio.

Nevertheless, many investors still blindly follow the traditional multi-asset class, multi-style model. This is a process that is being followed by institutional investors. However, it may not suit retail investors for various reasons such as expenses and taxes.

So, what should a retail investor follow? They should follow core and satellite strategy to design their portfolio.

Core

The ‘core’ part of your portfolio describes that portion of the equity allocation that is designed to capture the three market factor returns that is, beta, size and book to market or value. The fund forms a part of your core portfolio is general in nature as well as cost and tax efficiency forms the major considerations. The design of the core is a four-step process that mimics traditional asset allocation.

Equity allocation: Under this, you tend to determine the allocation between other assets, including fixed income and equities. One can use various methods to arrive at the percentage of allocation to equity.   

Selection of the equity investments: A simple and easy approach, especially for an investor who does not believe in factor returns, would be to allocate 100 per cent of the core to a broad-based market index like BSE 500. However, if you believe that factors play an important role in generating returns, you can have additional core allocations to small-cap and value or growth equities funds.

Determination of rebalancing parameters for core investments: The determination of the rebalancing criteria is a critical factor in the management of cost and tax efficiency. In general, you should go for the widest possible rebalance bands consistent with your financial goal and portfolio risk exposure.

Satellites

The main idea behind a satellite fund is to add spice to your portfolio that captures the latest trend and help you generate better alpha. They will tend to be poorly correlated with the core and hence, risk reduction through satellite diversification. In fact, although counter-intuitive to professionals, satellite investments need not be style consistent. The criterion that should drive the satellite investment is that it should be fundamentally strong and the expected return should exceed that of core investment. You can have two to four satellite positions. A higher number of satellite funds may add little to the net satellite alpha because additions are more likely to reduce risk than increase returns. Therefore, more effort should be made to select and monitor satellite investments.