Part II: An Investment Strategy Resistant to Market Crashes

Plus! Assorted links #8: How to pick a mutual fund, linearity bias, what is staking, why ETH is changing from Proof of Work to Proof of Stake and much more!

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Last week we saw the all-weather investing strategy by Harry Browne called the Permanent Portfolio (PP). In case you missed it, read here before you proceed.

In the 2nd installment of this series, we will look at how to implement the PP strategy. Let’s split the implementation into 3 parts:

1️⃣ Investing

2️⃣ Rebalancing

3️⃣ Exiting.

Disclaimer: I am no financial expert and I am not responsible for any losses you incur. Please consult with your investment advisor before you invest in any of the instruments mentioned below (they carry significant risk).

Investing 💰

Invest according to the split that you finalize on.

For example, if you are going with the 25-25-25-25 portfolio and you save 10k a month, put 2.5k in each of those 4 instruments. If you’re investing in mutual funds, automate via SIPs.

But the bigger question is this: where and how exactly does one invest?

Please note that my recommendations are better suited for passive style of investing that only involves index mutual funds and exchange traded funds (ETFs).

1. Platforms 💻

The two of the most popular platforms today are Groww and Zerodha.

They both check a lot of boxes:

✅ Responsive customer support

✅ Minimal bugs

✅ Rich and intuitive UI

But I chose Zerodha for one reason - the amount of work my nominee has to do in case I die.

In Zerodha, all your assets including mutual funds are held in a single place with a depository (CDSL or NDSL). If you die, your nominee(s) only has to file a claim with Zerodha. Zerodha also has the process clearly laid out. Groww does not.

In Groww, your mutual funds are not held by a depository but are held by the fund house (like UTI or Franklin Templeton). If you die, your nominee(s) would have to run around filing a claim in each of the fund house. Do you really want to put them through that kind of grind?

2 Instruments

Before we jump into each instrument, you need to know how to choose a mutual fund since it going to appear frequently in the upcoming sections.

2.1 Choosing a Mutual Fund

First things first - forget about these:

Every mutual fund has an objective. This objective is officially laid out in the mutual fund’s Scheme Information Document (SID).

This greatly simplifies things for us - a good mutual fund is simply the one that meets its objective.

Most mutual funds have an objective of beating a benchmark index.

💡 What is an index? 💡

From Investopedia: A market index is a hypothetical portfolio of investment holdings that represents a segment of the financial market. The calculation of the index value comes from the prices of the underlying holdings.

For example, these are the constituents of Nifty 50 index:

Nifty 50 is just one index; there are a lot of other indices. Find the benchmark index of the fund you are trying to assess by looking at the SID. For example, consider the Mirae Asset Large Cap fund. In the SID, search for ‘benchmark index’:

To judge its performance, see whether the fund has been outperforming the benchmark index i.e the fund should be giving better returns than the index consistently. But there are two kinds of returns: rolling returns and trailing returns.

Most charts that you see in newspapers and platforms like Groww, Zerodha etc only show the trailing returns.

You can read further here but long story short - rolling returns are far superior than trailing returns.

This is an easy-to-use tool that lets you compare the rolling returns of mutual funds. To use this tool:

  • Choose the fund(s) you want to compare on the left

  • Choose the benchmark index on the right

If we look at Mirae Asset Large Cap fund’s performance over a rolling window of 3 years, we get this:

You can see that this fund (purple line) used to comfortably outperform the index (grey line) until 2020. But even from 2020 till today, it never gave returns lower than the index.

🚩Red Flag: Whenever a fund gives returns lower than that of its benchmark index for extended periods of time (say more than a year), it is time for you to exit the fund.

These are the steps you need to take to choose a fund:

  1. Find the benchmark index of the fund(s) from its SID

  2. Check the rolling returns using the calculator

    • keep a rolling window of 3 years

    • check return windows of 3, 5, 7 and 10 years

  3. Compare multiple funds in the same category (i.e with same benchmark index) using the tool

  4. Pick the fund that outperforms the index the most (not by %-age returns but by consistency)

As a tie breaker, you can look at the total expense ratio (TER) .

💡Total Expense Ratio💡

It is the money you pay to the fund house for managing and operating the mutual fund.

This value keeps changing so a low TER today does not mean it will remain low in the future. Ideally, one should look at the historical expense ratio figures to see if the fund has been keeping it low consistently. But I have been unable to find this data so the current TER is all we can work with. (If you know where I can find this data, please let me know.)

2.2 Equity 📊

When it comes to equity, index funds are the easiest and simplest instruments to invest in. Index funds try to give the same returns as the index - this is called as ‘tracking’ the index. They are a passive mutual fund; the fund manager need not analyze and pick/exit stocks, they only invest in the companies that constitute the indices.

Basically, they are mutual funds on auto-pilot. This means a very low expense ratio (around 0.1% to 0.3%) compared to other active mutual funds which charge upwards of 1%.

How to choose a good index fund? Again, it’s all about the objective. The objective of an index fund is to track the index. Not to beat the index but to simply track it.

The amount by which the returns of a fund deviates from that of the index is called tracking error. Lower the tracking error, the better the fund. (Read further here.)

Let us compare 3 Nifty index funds: ICICI Prudential, SBI & UTI.

If we look at the particular period between 18th Aug 2017 and 18th Aug 2020, UTI Nifty has done the worst. It has outperformed the index instead of tracking it. SBI Nifty has done the best given how close it is the the returns of the index.

In the above screenshot, we are only looking at a particular time period. But when you are assessing, see which one closely tracks the index across all the time periods.

Note: The difference in return is only an approximation of tracking error. The actual tracking error involves a bit more calculation.

2.3 Gold 👑

You have 3 options: Gold ETF, Gold Mutual Funds or Sovereign Gold Bond (SGB).

💡Exchange Traded Fund💡

From Wikipedia: An exchange-traded fund is a type of investment fund and exchange-traded product, i.e. they are traded on stock exchanges. ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold throughout the day on stock exchanges while mutual funds are bought and sold based on their price at day's end.

While SGB has its advantages, they make it difficult to rebalance because:

  • They mature after 8 years and have a lock-in period of 5 years

  • You can sell it in the exchange before 5 years but the number of buyers/sellers is so low that you will find it hard to exit at the price you want

Unlike SGBs, gold ETF or gold MF make it easy to rebalance because you can sell it at the time you want.

If you are new to investing, go with a gold MF. Gold MFs usually invest in the respective fund house’s gold ETF (ex: Axis Gold MF holds 99% of Axis Gold ETF and the rest as cash).

If you are confident or if you feel adventurous, go for an ETF because mutual funds have the expense ratio of the fund on top of the expense ratio of the underlying ETF. However, do keep in mind the following:

  • Selling ETFs on the exchange attracts other charges like STT and GST

  • Purchase an ETF that is traded in high volumes consistently. You can check the trade volumes on NSE’s website. If the volumes are low, then you are entering a one way door; you will be unable to sell it or you will have to sell it at a loss.

  • The only gold ETF that has a reasonably high trade volume consistently is Nippon Gold ETF aka GoldBeeS (see pic below).

But educate yourself on the risks associated with ETFs before entering.

2.4 Cash 💸

Any liquid fund with low TER is ok.

2.5 Government Bond (GSec) 📋

The bond market is highly volatile and is harder to understand than the equity market. Again, please do your own research before getting into it. You can start here.

As for the instruments, there are a couple of options: direct purchase of GSecs, Edelweiss Bharat Bond ETF, and Gilt MFs to name a few.

👎 You can directly purchase GSecs through Zerodha but I would advice you to stay away from it. The liquidity is too low in the secondary market making it hard to exit.

💡Primary Market vs Secondary Market💡

Primary market is where the actual asset is issued. For example, an IPO is the primary market for stocks.

Secondary market is where the assets owned by people are bought and sold. These are the ‘stock exchanges’ like NSE/Nifty and BSE/Sensex.

👎 Bharat Bond ETF is another option but the trading volumes are too low.

👍 That leaves us with Gilt MFs. The rolling returns calculator does not have the index that gilt MFs try to beat. In such a case, the best we have is the trailing returns. You can use Value Research to see if the fund’s 3-year, 5-year, 7-year and 10-year trailing returns beat the returns of its benchmark index.

Summary

Instruments to invest in are:

  • Equity - Index MF

  • Gold - Gold MF/ETF

  • Cash - Liquid MF

  • Govt Bond - Gilt MF

Next week, we will look at how to rebalance your portfolio.

Check out Part III here.


This Week’s Interesting Reads

No rabbit hole for this week but we have a few interesting places to visit so buckle up!

The Maginot Line Problem

By Taylor Pearson

Blog | 17 minute read | Tags: Strategy, Human Psychology

Linearity Bias is the assumption that a change in one quantity produces a proportional change in another.

We have a bias for finding solutions that solve the immediate problem than one that addresses the underlying cause. In other words, we think too linearly and fail to see the broader pattern.

The French army paid a heavy price for thinking this way in WWI by looking at the problem too narrowly.

Ethereum into the ether

By Patrick O'Shaughnessy

Podcast | 1 hr 12 min listen | Tags: Web 3.0, Cryptocurrency

A great conversation on Ethereum and what is in store for it. The conversation is beginner friendly - starting from what blockchain is, how bitcoin works and how ethereum works.

After the intro, they dive into questions like what is proof of stake, what it means for ETH to shift from proof of work to proof of stake, how does it help reduce the climate change cost of crypto and much more.

Justin is a master at explaining complex concepts in simple terms (which is what makes him a master) so you will not be overwhelmed even if you are new to the crypto space (like me).

Quote of the week

“It ain’t what you don’t know that hurts you, it’s what you know for sure that just ain’t so.”   - Taylor Pearson's Dad

That’s all for this week!


All views expressed by the author are personal.

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