CONSTRUCTING A DIVERISIFIED PORTFOLIO

Investors typically (over) diversify across assets to reduce the downside risk in the stock market. Those who take the mutual fund route simply buy diversified funds. Others who construct self-directed portfolios, however, face a problem; for creating a diversified portfolio is not easy. How should investors create such a portfolio?

This article discusses the difficulty in constructing self-directed diversified portfolios. It then suggests a practical approach to creating such a portfolio within the core-satellite framework.

Correlation effect

Diversification as a concept was developed when Harry Markowitz argued in a seminal paper as to why it pays to invest in a basket of assets.

The diversification process is easy if the portfolio were to contain just two stocks.

Then, the investor has to simply ensure that the relationship (captured by correlation) between the two stocks is minimal (less than one).

The problem, however, comes when the portfolio has several stocks.

Computing the correlation that each stock has with every other stock in the portfolio becomes cumbersome.

Professional money managers use sophisticated optimisation models such as generalised mean-variance analysis.

Such programs and models make the process difficult for individual investors.

Besides, a self-directed diversified portfolio requires large initial capital. The reason is that the correlation among stocks has increased sharply in recent years due to globalisation. This means that a portfolio now has to carry more than the traditional 20 stocks to achieve diversification; a study in the US pegs the number at 200!

Moreover, every time a new stock is added to the portfolio, the investor has to keep in mind how the stock reacts with other assets in the portfolio.

All these issues make it practically difficult for an individual investor to construct a self-directed diversified portfolio.

Core-satellite effect

An easier approach would be to construct a portfolio within a core-satellite framework. This framework helps an investor take a diversified exposure with minimal effort.

The equity core would constitute of a low-cost index fund, preferably one on a broad benchmark index such as the S&P CNX 500.

The objective is to enable the investor take low-cost diversified exposure to equity as an asset class.

Given the limited choice of such funds in the country, investors can also consider index funds benchmarked to the Nifty or the Sensex.

The equity satellite can be either a self-directed portfolio or a portfolio of mutual funds. The objective of this portfolio is to generate excess returns over the benchmark index.

The point is that an investor need not be concerned with correlations and diversification for a self-directed equity satellite.

For one, such a portfolio is concentrated, as it strives to generate excess returns over a relatively shorter investment horizon compared with the equity core. For another, correlation structures are anyway not meaningful over the short term.

The case is somewhat different for an equity satellite consisting of a portfolio of mutual funds. In such cases, the objective would be to buy funds in diverse sectors and styles.

An investor can, for instance, construct a portfolio of mid-cap fund, emerging-market fund and bank ETF without being overly concerned about computing the correlation structures among these assets.

The equity satellite can also have a combination of sector funds and direct exposure to stocks.

That is, an investor can construct a portfolio of sector funds, emerging market fund and mid-cap stocks for style diversification.

This article does not delve into the merits of diversification as a risk-minimizing process. It simply offers a practical approach to constructing an equity portfolio within the core-satellite framework. The construction process for equity core is the same for mass affluent investors and HNWIs. The equity satellite portfolio for HNWIs is somewhat different in that it can also carry exotic exposure such as private equity and commodity futures. Investors should suitably combine bonds with equity to achieve diversification across asset classes.