In life, everything works better when it is balanced and wholesome in nature. For example, a balanced diet that includes the essential nutrients works better than an unplanned one. And the same can be said about fitness, and even studies — institutions often encourage students to be all-rounders. So when it comes to investing, our portfolios need to be balanced, to ensure a optimised asset allocation mix.
A robust investment portfolio is one that is diversified across asset classes, such as equities, bonds and commodities. Simply put, it has exposure to different categories of financial assets, and is tax efficient in nature — meaning it lets you minimise your tax outgo.
Most investors are aware of the benefits of creating a well-diversified portfolio but the real challenge comes in the execution. Choosing the right investment in each asset class, and monitoring them constantly for risk and performance can be a tedious task.
There exists a simple solution to all your portfolio requirements, in the form of index funds or ETFs.
Before learning how index funds or ETFs help in creating a robust long-term portfolio that delivers, it is paramount to know what exactly index funds and ETFs are. Both are basically designed to replicate an underlying index in terms of its composition and even performance.
This means that an index fund or ETF holds all the constituents of the underlying index, and in the same proportion.
Consequently, the returns generated will also be in line with the underlying index minus tracking any error.
For instance, a Nifty50 fund holds all the constituents of the in the benchmark index in the same weightage. Any move in the Nifty50 will be reflected in the the ETF or index fund.
The aim of the fund manager is to generate returns similar to the underlying index. Unlike active funds, the fund manager here will not be actively managing the portfolio to generate alpha. Further, the cost associated with an index fund or ETF tends to be minimal on account of lower transaction fees. This is because the only time the fund manager transacts is when there is a change in the underlying index.
Investors can use an index fund or ETF to build an optimally diversified investment portfolio and meet their multiple investment goals.
But how?
Firstly, from an asset class perspective, investors have the option to put their money in equity index funds, debt index funds, commodity index funds and global equity index funds. Even within the world of equity index funds and ETFs, there are funds that track the large-, mid- and small-cap indices.
This way, an investor can diversify across market segments. Besides, for equity allocation, the more evolved investor can even consider using a smart beta ETF based on parameters such as low volatility, alpha, value and momentum to spruce up the return potential.
An investor considering adding some sectoral allocation to a satellite portfolio can consider sectoral or thematic ETFs. These are spread across a variety of sectors such as banking, auto, IT, FMCG and healthcare, which means investors have a wide array of options to choose from.
Now, coming to the debt side of the portfolio, investors can choose between liquid ETFs, G-Sec ETFs or Nifty PSU Bond Plus SDL or Nifty SDL index funds.
The debt funds held for more than three years are eligible for indexation benefits. Equity index funds are taxed like equity funds, which makes them tax efficient.
When it comes to commodities, investors have the option of gold and silver ETFs to diversify their commodity exposure. Almost all of the portfolio requirements of an investor can be optimally met using the combination of an index fund and an ETF, and that too in a cost-effective manner.
Clearly, with passive offerings like index funds and ETFs becoming more popular and innovative, investors have the unique opportunity to create an entire portfolio more easily and optimally meet their investment requirements.
Chintan Haria is Head-Product Development and Strategy at ICICI Prudential AMC. The views expressed in this article are his own.
