Diversified funds for core portfolio?

Diversified funds for core portfolio?

The core-satellite framework is an optimal form of portfolio construction. In this framework, investors use index funds to construct the core portfolio and some genre of active funds to build the satellite portfolio.
A question many investors ask is: Can active funds be used to construct the core portfolio?
This article discusses the characteristics of active funds available in India.
It shows the problems in using such funds as part of the core portfolio.
It then suggests why some active funds provide optimal exposure within the satellite portfolio.
Style mandate
Active funds are those funds that strive to beat their benchmarks.
The portfolio managers of such funds take active bets — either through stock selection with simultaneous diversification across industries or with sector rotation, which is actively picking sectors that outperform the market and holding diversifying positions within those sectors.
Such funds then ought to be a natural choice for investors.
The problem, however, is the funds’ style mandate. This refers to the investment style that an active portfolio manager follows.
A large-cap value, for instance, is an investment style where the portfolio manager will pick large-cap stocks based on certain parameters such as price-earnings or price-to-book multiples.
If investors use active funds to form the core portfolio, they should ensure that the portfolio is style-diversified to avoid concentration risk.
The problem is that most active funds do not have clearly defined style mandates. This poses problems in portfolio construction.
Take an investor who buys three active funds. With no distinct style mandate, the portfolio managers of all three funds can technically load their portfolios with similar stocks. And that could expose the investor to concentration risk.
That is not the case with index funds. With the portfolio constituents of such funds clearly defined and broad-based, an investor has to buy one index fund or at best two (based on fees and tracking error) to construct the core portfolio.
Actives and MERs
The objective of the core portfolio is to take beta exposure through large-caps. The problem is that active funds generate returns from some combination of exposure to large-caps and mid-caps.
It is moot whether consistent excess returns can be generated from the large-cap space.
If, indeed, diversified funds generate active returns primarily from mid-cap exposure, why should investors pay active fees for large-cap exposure as well?
Consider this. The management expense ratio (MER) for active funds ranges between 2 and 2.5 per cent; the MER for an index fund is around one per cent.
Do active funds deliver returns commensurate with the higher fees?
Based on statistics from valueresearchonline.com, the median r-squared for diversified funds is 0.91 while the average r-squared is 0.89. That means, on average, 89 per cent of the variation in the fund returns can be explained by the changes in the benchmark index.
Of course, despite the strong relationship with benchmarks, some active funds do generate excess returns.
But when such returns primarily come from mid-caps, investors might as well take exposure to pure active mid-cap funds and settle for a low-cost large-cap exposure through index funds.
This argument sits well within the core-satellite portfolio framework, which encourages large-cap exposure through the core portfolio and all other exposure through the satellite portfolio.
Conclusion
The argument then is not against active funds per se but the investment style of most diversified funds.
It logically follows that style-specific active funds would be optimal for the satellite portfolio. This portfolio is set up to take exposure to sectors that can generate excess returns or alpha returns.
Active mid-cap funds and small-cap funds, for instance. The reason is that investors do not have low-cost alternatives in this investment space. Besides, the likelihood of beating benchmarks is higher.
Finally, these funds have clearly defined style mandates.
All these factors make them suitable for the satellite portfolio. And the index funds for the core portfolio.