Whats Your Portfolio Strategy?

Investing in a mutual fund is not an ad hoc process. It requires a disciplined approach that will help you choose the right portfolio strategy in order to achieve your financial goals, some of which may be your ‘needs’ and some would be ‘wants’. In this article, we highlight the various strategies and zero down on the core and satellite portfolio strategy that is best suited for most of us. 

Iconic investor Warren Buffet once said, “We don’t have to be smarter than the rest, but we have to be more disciplined than the rest”. It is a maxim that is apt to the world of investments, which requires a more disciplined approach. Mutual fund investment, and especially investing through the Systematic Investment Plan (SIP) route, helps you to maintain that self-restraint and moderation or regimen. Building the right mutual fund portfolio calls for a disciplined approach and proper planning. Constructing a ‘right portfolio’ may sound simple but selecting a strategy to build a right or constructive portfolio that suits you is quite complex. There are various portfolio strategies available to select from.

Hence, it is crucial on your part to identify and implement a portfolio strategy that best suits your circumstances and needs. While it is important to know the objective of your investment before deciding on your portfolio strategy, knowing your risk appetite is also equally important. This is because your risk appetite will determine your asset allocation. There are various portfolio strategies available for investors, namely, bucket strategy, permanent portfolio strategy, classic balanced strategy, dynamic portfolio strategy, and core and satellite portfolio strategy. We will explain all these strategies in detail and you can choose the one that matches your requirement and temperament.

Bucket Strategy

Bucket strategy is one of the famous portfolio strategies often used in retirement planning. However, there are many who use this portfolio strategy even for the non-retirement period. In this strategy the entire planning period is divided into different parts known as buckets. Every bucket has different investment avenues attached to it. Say, for instance, the planning period is divided into three buckets, namely, short-term, medium-term and long-term. The investment attached to the short-term bucket might be cash and short-term debt funds. The mediumterm bucket might have medium-term debt funds, and some exposure to equity mutual funds.

And the long-term bucket would have higher exposure to equity and some to long-term debt funds. Even within this broader asset classes, the selection of sub-asset classes will depend on your risk profile. This portfolio strategy often helps you to reduce your investment risk to some extent because of diversification across tenure and products. However, this strategy has proved to be more useful during retirement rather than in any other period. The reason is that the retirement phase is always a predetermined scenario whereas the preretirement period is very dynamic in nature and needs to be dealt with it as and when it comes.

Permanent Portfolio Strategy

This portfolio strategy was devised by a free-market investment analyst, Harry Browne, in the 1980s. This was designed to perform well in all economic conditions. Browne stated that equal allocation between growth stocks, precious metals, government bonds and treasury bills (cash) would be an ideal investment mix for those investors seeking safety and growth. He believed that this portfolio strategy would prove to be profitable in all types of economic situations. This means that growth stocks would prosper in expansionary markets, precious metals in inflationary markets, government bonds in a recessionary phase, and treasury bills or cash in depression.

Such a portfolio strategy doesn’t generate better returns than other portfolio strategies as growth stocks account only for 25 per cent of the entire portfolio. However, in case of downfall in the equity market, this portfolio is the one that would contain your losses because only one-fourth of the asset is invested in stock. Let’s consider an example to understand it better. Assume that you want to invest Rs 1 lakh. As per this strategy, you would be investing Rs 25,000 each in Sensex, ten-year sovereign bond, gold and cash for 20 years for the period 2000 to 2019. With this approach, your investment of Rs 1 lakh in the year 2000 would further grow to become Rs 6.47 lakhs in 2019. That implies a compounded annual growth rate (CAGR) of 9.79 per cent. In terms of risk, its standard deviation stands at 0.08.

Now if we look at the CAGR of Sensex and the ten-year sovereign bond in the same period, they are at 10.60 per cent and 8.09 per cent, respectively. Also, the standard deviation of Sensex stood at 0.33 and for the ten-year sovereign bond it stood at 0.10. This clearly shows that the permanent portfolio strategy reduces risk and provides better risk-adjusted returns. However, investing solely in equity has given better returns than this portfolio strategy, but of course that has come with higher risk. This portfolio is not suited for investors who are investing according to a financial plan. This is more apt for investors who are new to investing and just want to get started or for someone who is a moderate risk-taker and wishes to plan for his or her retirement. 


Classic Balanced Strategy

This is one of the oldest portfolio strategies, according to which it is better to invest in equity and debt in equal proportions. This strategy follows the principle of growing when the market booms and sliding less when the market crashes. In the above example, if we had adopted this strategy for the period 2000 to 2019, the CAGR generated by this strategy would be 11.42 per cent and its standard deviation for the period would be 0.14. If we compare this strategy with the permanent portfolio strategy, it becomes obvious that the permanent portfolio strategy proves to be a better option in terms of downside risk. However, to get a reasonable balance of risk and returns, the classic balanced portfolio strategy is better.

Dynamic Portfolio Strategy

This portfolio strategy is dynamic in nature, it depends on equity market valuations. If the equity market valuations are high, they shift your investments to more conservative asset class, and vice versa. This strategy helps to dynamically manage the risk of the portfolio and maximise returns. Let us assume that the market (Sensex) is valued based on its price to equity (PE) ratio. Thus, when the PE moves higher compared to its long-term median, part of the equity investments is shifted to debt, and vice versa. For the period 2000 to 2019, the implementation of this strategy would have generated annualised return of 13.65 per cent. In terms of risk, standard deviation and downside deviation stood at 0.15 and 0.03 respectively. This strategy attracts more risk but greater returns. In this case, building and managing your portfolio has a limitation because it cannot be assigned to any goal. This strategy is therefore well-suited for people seeking wealth management. It is to be noted that the allocation between equity and debt is based on the PE of the respective year with respect to a 20-year median PE.


Core and Satellite Portfolio

Strategy The basic principle behind the core and satellite portfolio is that the portfolio gets split into two major parts. One part of the portfolio follows the core strategy which is relatively stable and low on volatility and the other segment follows the satellite strategy, which seeks higher returns or alpha and is potentially high on volatility. So, what are the basics of the core and satellite investment strategy? The core investment strategy takes a conservative approach of investing and its main objective is to build a relatively stable portfolio. It usually goes for investment with lower risk-return profile.

Also, this strategy is passive in nature which means occasional or no re-jigging of the portfolio at all with respect to the market dynamics. Large-cap funds, index funds, large-cap ETFs, short-term debt funds, gilt funds, etc. form part of the core portfolio. However, the percentage allocation to assets depends upon your risk appetite. This segment of the portfolio is usually directed towards achievement of your financial goals, especially those that can be identified as ‘needs’. The satellite investment strategy is sort of aggressive in nature and its main objective is to generate higher returns.

The role of a satellite portfolio is to provide investors with an opportunity to position their portfolio so that it can exploit the opportunities presented by market dynamics to get higher returns. Therefore, this strategy requires active management. The investments that are the part of this strategy are mid-cap funds, small-cap funds, thematic funds, sectoral funds, credit risk funds, dynamic bond funds, long duration funds, etc. The asset allocation would depend on your risk appetite. They are more targeted towards achievement of financial goals that are ‘wants’. This strategy is even used for wealth management.


Building a Core and Satellite Portfolio

There are various ways to build a core and satellite portfolio. However, we propose going with the financial goals’ approach. The reason is that when you invest towards certain objectives you can reduce your risk of non-achievement of financial goals. This is done through selection of the right asset class that suits your risk appetite and goal tenure. Consider, for instance, that one of your financial goals matures in three years and the other matures in seven years. In such instances, it calls for multiple portfolios. Each portfolio is dedicated towards fulfillment of each financial goal. Further, the product selection depends on your time horizon and risk appetite.

Also, while dealing with this strategy you need to segregate your financial goals between needs and wants. To make it clear we have taken a case study of three friends that will help you to understand how core and satellite portfolio works.

Case Study

Take for example three friends – Sagar Shah, Mohit Patel and Sanket Rao – with different financial goals and varying risk appetite. We will build a core and satellite portfolio for them so that you may understand how it actually works. 

Portfolio A

IT professional Sagar Shah (34) lives with his wife and two-year old daughter. He is a conservative risk-taker. His financial goals are to accumulate for child’s graduation starting 18 years from now which currently requires Rs 5 lakhs; go for an international vacation after two years from now with present value of Rs 2 lakhs; and accumulate retirement corpus worth Rs 1.5 crore over the next 26 years.

Portfolio B

Mohit Patel (35), a marketing professional, lives with his wife and five-year old son. He is a moderate risk-taker. His financial goals are to buy his first residential flat worth Rs 50 lakhs in the next seven years wherein he currently has investment worth Rs 5 lakhs dedicated towards this goal; wants to fund his son’s higher studies in a foreign country which would be due 17 years from now for which he currently requires Rs 15 lakhs to achieve this goal; and plans to build an emergency fund in the next one year worth Rs 3 lakhs while currently holding Rs 1 lakh in bank FD and Rs 50,000 in his savings bank account.

Portfolio C

Sanket Rao (34), a banker, lives with his wife and two daughters, five and seven years old. He is an aggressive risk-taker. His financial goals are that he wishes to upgrade his car to a bigger car worth Rs 15 lakhs in five years from now and wants to plan for both the daughters’ graduation, about 15 and 13 years from now, respectively with the present value of the goal being Rs 5 lakhs.

Now that we have all the details, we need to make certain assumptions. 

Our suggestion to Sagar Shah is that for his daughter’s graduation goal and retirement goal, he should choose the core portfolio and for the international vacation he should adopt the satellite portfolio. 

We recommend a core portfolio for his daughter’s graduation and retirement goal as they are his needs, and this requires a more stable portfolio. As the international vacation goal is his want, a satellite portfolio is recommended.


Our suggestion to Sanket Rao is that for both his daughters’ graduation goal, he should go with a core portfolio and for the car goal he should adopt a satellite portfolio. 







We have suggested him core portfolio for both his daughters’ graduation goal as they are his needs and it therefore calls for a somewhat stable portfolio. The car goal is his want and therefore a satellite portfolio was suggested.

Conclusion

We may conclude that core and satellite portfolios are quite suitable for most of us. The reason is that most of us have financial needs that we need to fulfill. This may be the education of your children, their marriage or your own retirement. Hence, the portfolio strategy would suit each such individual. This strategy is more inclined towards financial planning and most of the other strategies explained in this article are more tilted towards wealth management.

Thus, if you are a person who still has no emergency fund in place or are not properly insured, etc., we advise that you should get a financial plan in place and set about to achieve your financial goals with a core and satellite portfolio strategy.

Also, remember that a core portfolio is for your financial ‘needs’ and a satellite portfolio is for your financial ‘wants’. However, if that’s not the case then you can go with any of the wealth management strategies. Also, while selecting your wealth management strategy, do check out the right strategy that would suit your requirements. However, a dynamic portfolio strategy is the one that proves to be a better strategy for wealth management though it is not suitable for everyone on account of its aggressive and active management nature. 

Note: The assests suggested are based on their respective risk profile and goal tenure.