An examination of various client portfolios at the end of December 2015 has shown that high-risk portfolios of our clients have significantly outperformed their benchmarks; however low-risk portfolios, while not losing money in absolute terms, have underperformed their respective benchmarks (SBI one-year FD rate or CPI rate of Inflation + 2%). The content of this blog is an attempt to explain why underperformance has occurred and how this very underperformance in the short term should provide significant upside potential for these very same low-risk portfolios.

Our philosophy in portfolio construction has been to have a dumbbell strategy. On one hand we would have a rather concentrated portfolio of high-risk, high-conviction ideas in specific stock opportunities and on the other hand, we would have low-cost index-based equity, long-term bonds/bond funds and a generous dollop of short-term fixed income instruments such as liquid funds or cash. So for example, the highest risk portfolio would have about 80% exposure to the high risk, high conviction idea basket and 20% cash for optionality. On the other hand a very low-risk portfolio would have no exposure to the high risk basket, some exposure to low-cost, index-based equity, some exposure to long-term bonds/bond funds and again about 20% exposure to liquid funds or cash for optionality. The idea is to embrace risk and volatility when it is desired and if not, to simply undertake a low cost diversified index approach.

The past one year has seen the headline equity indices drop by ~5% in absolute terms, and it is this drop that has dragged portfolio returns in low-risk portfolios. Nevertheless, low-risk client portfolios have been significantly shielded through of course keeping exposure to index-based equity low in accordance to the respective investment policy statements and also by making ONLY staggered entries. The critical point is that even low-risk portfolios require an element of equity exposure through index-based equity ETFs/Mutual Funds to outperform a low risk benchmark such as CPI rate of inflation + 2%. By taking staggered entries into index-based equity, not only have client portfolios been protected from significant draw-down, they have created rupee cost averaging opportunities which will play out significantly well for these very same portfolios when the headline equity indices rise again.

The wisdom of maintaining exposure to equity risk within client comfort levels and lowering timing risks by taking staggered entries is playing out currently with our client portfolios significantly shielded from the drawdown in the headline indices even when underperforming low-risk benchmarks. Most Indian stock market pundits are saying that the year ahead is that of stock picking and that the headline indices will underperform. While this may be true, the key point for low risk portfolios is that the benchmark is CPI inflation + 2%. In this context, if we believe the headline indices are bound to beat this benchmark over the next three years, why should we take on specific stock risk – specifically for these low-risk portfolios? I thus maintain that low risk portfolios must avoid individual stock picking and keep allocating to low-cost, index-based equity in a staggered way while keeping overall allocation to equity significantly within client comfort zones.

Wishing all our dear clients a very happy 2016 !!