Benchmark for life

Equity allocation can enhance your investment portfolio’s expected return

Benchmarks are important for equity investments. If you buy an exchange-traded fund (ETF) or an index fund, you want to know how closely the fund mirrors the benchmark index. If you buy an active fund, you want to ascertain if the fund consistently beats the benchmark index. In this article, we discuss whether the benchmark you choose should change based on goals for which you are making the investment.

Goal benchmarks

You should first decide on your benchmark and then choose an appropriate fund based on the same. The benchmark you choose should represent all or a substantial proportion of the market capitalisation of stocks listed on an exchange. Why? Your objective of investing in equity is to improve expected return on your goal-based portfolio.

If you were to invest all your savings in bank deposits, given the low returns, your savings must be sizeable to achieve your goal.

By allocating some of your savings to equity, you can enhance the expected returns on your portfolio.

Note that you are betting on equity as an asset class, not on individual sectors or styles. Therefore, a fund that is benchmarked to a broad-cap index would suffice.

This argument is the same whether you pursue a goal for buying a house or funding your child’s education during your working life. Therefore, your choice of benchmark is not dependent on your life goals.

Your preferred benchmark should be the NSE 500 Index, a broad-cap index, or the S&P BSE 500 Index.

If broad-cap funds on either benchmark are few, or if do not prefer such funds, you could consider large cap funds benchmarked to Nifty 50 or BSE Sensex. This is because a large-cap index captures substantial proportion of the market capitalisation of all the stocks on an exchange.

Your investing life spans the time you start investing till you live. You typically tend to take more risk when you are young than when you are approaching retirement, and even less after retirement.

Yet, through your investing life, you must invest in equity. You can choose how much to invest in equity, not whether to invest in equity. As you age, your objective changes from intermediate goals such as buying a house to eventually saving for retirement and then for meeting your post-retirement living. Your choice of benchmark should remain the same through your investing life. Why?

During your working years, investing in equity enables you to free more cash flows from your monthly income to meet your current consumption. This is because of the higher expected return on equity compared to bonds. During your retirement, higher expected returns on equity can help meet inflation-related stress on your cash flows; higher inflation could mean higher healthcare and living expenses.

So, whether you are a working executive or a retiree, you want a broad exposure to equity to capture higher returns. Note that your choice of benchmark is independent of whether you choose a passive fund or an active fund.

Conclusion

Your equity allocation is a primary driver for enhancing your portfolio’s expected return. The next important driver is your choice of benchmark.

Finally comes your choice of whether to invest in an active fund or a passive fund for your goal-based portfolios. The more important your goal is, the more you should be inclined towards passive funds.

Remember this: A fund beating its appropriate benchmark is dependent on the portfolio manager’s skill and luck. You choosing an appropriate active fund requires skill, and luck too!

(The writer offers training programmes for individuals to manage their personal investments)

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