Mutual Funds Strategy 113: Creating a model portfolio with mutual funds and equity
Have you heard of the term “model portfolio” before? I am quite sure 90% of investors would not have heard this, as most of them are Do-It-Yourself type of investors.
The real reason most of the investors would not have heard about “model portfolio” may be because they would not have met a professional investment advisor. Only an experienced advisor can create a model portfolio for you, and guess what? It would be a paid service.
An investor and his investment advisor have the same relationship as a patient and his doctor. If you have a medical history, would you refrain from disclosing it to the doctor? Just like that, an investor would not hide the financial history/transactions with his advisor.
Trust has a huge role to play both in medicine as well as investments. It took many years before doctors got the acceptance level to what we have now. Even then, in the rural parts of the country, people self-treat and rarely visit a doctor. Just like that, the concept of an investment advisor is relatively new, and only a small fraction of people are really using it.
(Long article alert: read it in your spare time.)
A model portfolio is a program or system that defines the strategic allocation of each client’s assets. On a basic level, we can divide the investor base into these main categories
- MP1 — People in their 20s, unmarried and just starting their careers. No other dependents.
- MP2 — Just married, single kid and single source of income. No other dependents.
- MP3 — People in their 40s & 50s, 2 or more kids, dual source of income, parents + children as dependents.
- MP4 — People in their 60s, retiring soon. No dependent children but dependent parents.
- MP5 — People in their 70s, no active source of income, and are retired. No dependents.
The above list is not final, we can create any number of model portfolio categories. Most likely, an investment advisor could have somewhere between 5 to 10 model portfolios, I have 8.
In each of the portfolios, the allocation to equity, debt/fixed deposits, savings deposits/emergency funds, gold, REITs, and international equity changes. For ease of tracking, I do not count physical assets like real estate and physical gold in these portfolios. The reason is that it is hard to rebalance physical assets.
Let me pick just one among the 5 and illustrate the allocation percentages because explaining all 5 would make this article ultra long and boring.
MP3 seems the most complicated, so let me break that down into simple steps. Consider the following members in a household.
- Husband — 45Y(earning member)
- Wife — 40Y(earning member)
- Son — 14Y(dependent)
- Daughter — 11Y(dependent)
- Father — 75Y (dependent)
- Mother — 70Y (dependent)
There are 2 income earners and 4 dependents. The nature of income should be such that it should cover the expenses of all 6 members, and there should be something in excess to save/invest.
Let us assume their total income is 3,00,000, and their expenses + rentals + emis are 2,00,000 per month. This means 1,00,000 is available to save/invest.
An ideal portfolio for them could be
- 15% into an emergency fund/liquid mutual funds.
- 45% into equity mutual funds.
- 15% into gold mutual fund/ETF.
- 15% into long-term debt mutual funds.
- 10% into direct equity stocks via demat.
That means out of 100000 they are saving:
- 15000 goes to a liquid fund.
- 45000 goes to equity mutual funds.
- 15000 goes to gold mutual funds.
- 15000 goes to debt mutual funds.
- 10000 goes to direct stocks.
A total of 90000 goes to mutual funds, and 10000 goes to direct stocks.
The equity mutual fund percentage of 45% could be further segregated as.
- 50% to large caps, i.e., 22500 rupees.
- 25% to medium and small caps, i.e., 11250 rupees.
- 25% to sectoral or thematic funds, i.e., 11250 rupees.
The 15000 that goes to debt mutual funds could be further segregated as.
- 50% to short/medium-term debt, i.e. 7500 rupees.
- 50% to corporate bonds or gilt fund, i.e. 7500 rupees.
This is a sample portfolio; the investment advisor got some numbers to crunch, and he designed a base case. Creating is just one part; the real work is in the rebalancing if a segment of the same has run up or lost ground. for eg:
- Equity markets crash 15%.
- Gold outperforms the markets by 25%.
- Gilt funds show underperformance and may need a switch to dynamic bonds.
Rebalancing is also required if the financial goals/situations change, for eg:
- 14 year old son might require a professional coaching/tuition centre admission.
- 75 year old father could have a medical emergency.
- 45 year old husband gets a job transfer and has additional expenses in a new city.
- 40 year old wife gets additional 15% performance pay.
The portfolio allocation could change drastically once the life stage changes. People could go from MP1 to MP2 after a quick marriage. They could go from MP3 to MP4 if their kids get a scholarship and are no longer dependents.
The essence is that these are just templates, and the actual portfolio required could be an improvised version. No two customers could have the exact same portfolio, the exposure could have a 70 to 85% overlap.
During presentations, I usually get the question of why a family earning 3L per month is only allocating 10k for direct equity. The answer is centered around the financial literacy aspect.
If the client is well aware of the reward:risk profile of stocks, then there is no harm in allocating a higher percentage — upto 25% on stocks. For someone new to this field, a mutual fund is the right choice as the drawdown is handled better than individual stocks. A 6 to 9 month journey through the mutual fund will give them a basic idea on how a stock works. Even then, only a handful of them pivot to stocks as most of them are comfortable with the kind of risk:reward offered by mutual funds.
In Table 1.1, I have given a generic asset allocation based on age. You should also be aware that age is just one factor determining asset allocation. The other variables are:
- Income to debt ratio.
- Propensity to save.
- Risk appetite & tolerance.
- Preference of Tangible vs Intangible assets.
- Ancestral wealth.
- Expense ratio.
So the exact selection of asset class depends on a combination of the above factors and not just the age. So it would not be prudent to just go by the above table and invest as it is.
Having said that, you should really get your model portfolio created too. Just throw in 3 to 4 asset classes and try to create one for yourselves. Seek professional help only if you are stuck; even a DIY designed model portfolio could do wonders than blind investing. Just don’t make the assumption that you need to invest in 100% equity to make a truckload of money. Add debt, gold, REITs, and international equity to your portfolio as well.
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