How did you pick which asset classes to invest in?
Research has proven many times over that the best path to maximizing returns for a given level of risk is by combining a diverse range of asset classes. So the first step in our investment process involved searching for a broad range of asset classes that were easily accessible within the Indian market. Then, we looked at how the asset classes performed historically, how volatile they were, how correlated they were, and what we thought their long-term trends might be. Finally, we used our discretion on which asset classes to add to the portfolio and which to avoid.
The four major types of asset classes are:
- Equities: These represent pieces of a company, also called stocks.
- Bonds: A bond is a loan to another entity (like a company or a government). In return for that loan, the entity pays you a fixed amount of money a year, called a ‘coupon.’ Because you get a fixed return for loaning out that money, bonds are also called ‘fixed income’ securities. A bond is a type of debt instrument - the borrower is indebted to the lender.
- Real estate: This includes land, apartments, houses, offices, and buildings.
- Commodities: These are raw materials like gold, silver, copper, iron ore, and oil.
Indian investors have historically preferred real assets (things they can touch and feel, like gold and real estate) to financial assets (things that derive their value from some underlying asset, like stocks and bonds). Real estate and gold combined already makeup 65% of Indian household wealth (!), while equities make up a measly 4%. In the US, equities (32%) make up a more significant proportion of household wealth than real estate (24%). Gold investment is negligible. Given our inherent bias towards real estate and gold, we wanted to leave them out of our asset allocation model.
There are a couple of broader things to keep in mind when picking asset classes:
- There is a risk vs. return trade-off to consider when picking assets. In general, when you take a greater risk, you are compensated with a higher return for taking that risk.
- The correlation between assets is an important consideration. Correlation is an indication of how closely two or more things move together. Ideally, you want an uncorrelated portfolio of assets - i.e., a collection of things that won’t all move in the same direction at the same time.
Which asset classes did you pick?
Here are the asset classes we picked, from least risky to riskiest:
- Liquid funds are mutual funds that lend to very safe entities like high-quality companies or the government for a very short period (at most 91 days). Because the borrowers are so safe, and the loan period is so short, liquid funds are some of the safest investments out there. However, we know that there is a trade-off between risk and reward. Liquid funds tend to be low on the return spectrum. They offer a slightly better return than your bank savings account or an FD (Fixed Deposit). They are helpful when you need to invest for the short term and don’t have the capacity to take a lot of risk.
- Debt-like represents a category of funds that gives (you guessed it) debt-like returns - consistent and with low volatility over long periods. However, they do this by investing in non-debt securities. This is a special category called arbitrage funds. Debt-like funds provide slightly higher returns than liquid funds to compensate for the fact that they may be more volatile in the short term. They are more tax-efficient than other debt funds, which is why we like them.
- Govt bonds represent loans made to the Indian government in return for a fixed annual return. Govt bonds are the safest form of local debt you could invest in. They have historically provided stable returns that have been uncorrelated with the Indian equity market, with low volatility.
- India bonds represent loans made to high-quality Indian corporates such as HDFC, SBI, Reliance Industries, and Tata Steel. Compared to Govt bonds, India bonds provide higher returns to compensate for the fact that lending to companies is riskier than lending to the government. However, these bonds are still considered relatively safe.
- India large cap equities represent an ownership in Indian corporations that have a market cap greater than Rs 20,000cr. Market cap (short for capitalization) refers to how much a company is worth. For example, Reliance Industries has a market cap of Rs. 15 lakh crore and is considered a large cap company. These large companies are considered safe because they have stood the test of time and are built to withstand significant shocks. They belong in every portfolio.
- India mid cap equities represent an ownership in Indian corporations that have a market cap between Rs. 5,000cr and Rs. 20,000cr. They are considered riskier than large caps because they are smaller and hence less protected. However, we expect them to perform better in the future to compensate for that risk.
- India small cap equities represent an ownership in Indian corporations that have a market cap less than Rs. 5000cr. They are the smallest group and hence the riskiest, but also offer the potential for the greatest returns.
- US equities represent an ownership share in US-based corporations. The US has the largest economy and stock market in the world. Although the US economy was hit hard in the 2008-2009 Financial Crisis, it is still one of the most resilient and active in the world because it is powered by a remarkable innovation engine.
How did you pick which funds to invest in each asset class?
For each asset class, there are broadly two types of funds:
- Passive funds, which just track that asset’s market and
- Active funds, which try to beat the asset’s market.
A significant amount of research has been published that shows active funds not only underperform the market, but those that outperform in one period are unlikely to outperform in subsequent periods (i.e. their returns are due to luck).
In fact, over the last five years, 90% of Indian large cap active funds have underperformed the benchmark index.
We believe it’s not worth playing those odds or leaving things to luck. We prefer to stick to passive funds and instead focus on other criteria for selection:
- Cost: All things equal, we choose funds with the lowest expense ratios (annual fees).
- Tracking error: Even passive funds don’t always exactly track the markets they’re supposed to replicate. This difference is called a tracking error. We try to choose funds with the lowest tracking error.
- Liquidity: Liquidity means how easy it is to buy or sell something. We want to make sure that the funds we pick have sufficient liquidity so that we can buy or sell large amounts for our customers at any time.
- AUM: AUM stands for Assets Under Management. A large AUM is a good indicator that several investors trust the fund and that it has been around for a long time.
How did you decide how much to allocate to each asset class?
Great question. In fact, it was a question that had been bothering investors for ages until a genius named Harry Markowitz pioneered the ‘Modern Portfolio Theory’ in 1952. The theory defines a framework to decide how much to allocate to each asset class in a portfolio in order to maximize return for a given level of risk. Markowitz was later awarded the Nobel Prize in economics for his theory.