The ‘increasing SIP’ is a common real-life situation. Consider a long-term fund investor who commits roughly the same percentage of his income to equity funds every month. As compensation and savings increase, the quantum of commitment to the market also increases. At the same time, inflation will run at varying rates and the purchasing power of money will, therefore, get eroded. The combination of an increasing SIP (systematic investment plan), long-term inflation and the volatility of equity returns makes it hard to calculate the internal rate of return for such an investor. But, this profile is common. One can assert that the long-term return is likely to be comfortably higher than for other assets. Should such an investor hold a basket of diversified active mutual funds (MFs)? Or simply focus on exchange-traded funds (ETFs) and index funds? Portfolio theory and the global experience say the latter is more sensible. Index funds usually outperform diversified active funds in most markets.
However, this is not true in India, where active funds have a long history of strong outperformance over their benchmarks. What’s more, many funds have outperformed consistently for years on end. This could be for multiple reasons. But, the statistical record is too powerful to be ignored: The long-term SIP investor in active diversified funds with a decent record is very likely to get better returns than the passive index one. Another point worth noting is that many diversified funds have very similar portfolios. While over-diversification is not ideal, there’s no sense in holding several versions of the same portfolio. Given two funds with similar portfolios, the net asset values (NAVs) and historic long-term returns will be different, depending on when the stocks were purchased and at what weight. But, if you’re buying those two funds at the same time, the future returns will be much the same.
Therefore, it’s better to avoid duplication. But, you could argue over what level to tolerate. Funds will never hold exactly the same portfolio. Weights will be different and some stocks will not be in common. Equity being what it is, one big multi-bagger could make a serious difference to long-term returns. So, even small differences may be critical. For what it’s worth, mid-caps or small-caps are more likely to turn into multi-baggers. But, the weight of a potential multi-bagger stock in the overall portfolio also counts. If a ‘bagger’ stock has a weight of one per cent and it grows to two per cent, it won’t make much difference to overall returns. The investor should, therefore, set a cut-off for minimum desirable diversification between funds.
Should one look for relatively high concentrations of a portfolio in a fund? Opinions are sharply divided on this but a concentrated portfolio carries both higher risk and more potential upside. A stock with a high weight could be a multi-bagger or alternatively, suffer big losses.
Apart from portfolio concentration and diversification, look at the betas of the funds you choose. Hold both high-beta and low-beta funds if you want respectable performance across market cycles. Hold high-beta if you want outperformance and low-beta if you are looking for defensive strength. Going by India’s market history, there will be long periods when returns from equity-oriented portfolios won’t keep up with inflation. There will also be other periods, like the past two years, when huge returns in excess of inflation are generated. Over time, investors with an increasing SIP are likely to discover their asset allocation is very highly equity weighted because equity generates capital gains over the long term. These investors should maintain an overall balance of several assets, though it’s up to the individual to decide how high the equity exposure and overall asset allocation should be. When returns are exceptionally high, booking profits and switching some part of the portfolio into debt, for example, makes sense.
Markets follow cyclical patterns of boom-bust and valuations tend to top out around the same or similar levels in each cycle. Valuations are at historic highs for many stocks. But, there are a few differences to take note of, this time around, compared to market history. The business environment is changing due to the goods and services tax (GST). Inflation is at a historic low as well. Both these factors should help sustain high valuations. Nevertheless valuations seem too high for comfort. It’s a good time to review portfolios, book some profits in equity and reallocate asset weights.