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B. Venkatesh

Readers of this column would know about the core-satellite portfolio framework.

It is a portfolio construction process where index funds form part of the core portfolio and alpha-strategies constitute the satellite portfolio.

Active traders do not buy mutual funds; they prefer to take direct exposure to equity.

The question is: Can the core-satellite portfolio framework apply to such traders as well?

This article discusses how self-directed portfolios can sit well within the core-satellite framework.

It explains why traders should setup a self-directed passive core along-side their trading portfolios.

It also shows why such passive core would be optimal only for large asset size.

Active traders typically construct concentrated portfolios. Such portfolios can generate high returns if the active bets turn successful.

The flip side is that such portfolios run high downside risk. So, why then do traders set up such positions?

The virtue is in the higher risk-adjusted returns.

Portfolio diversification is a risk-minimising process. Trading is a profit-maximising process.

And concentrated portfolio fits well within this framework.

It is important to understand the process that traders follow in setting up concentrated portfolios.

Hedge funds also set up such portfolios; they run proprietary models that may consider factors such as sector caps and co-movements between stocks.

Traders, however, buy one stock at a time without regard to its co-movement with other positions held.

Their objective is to buy and sell, and not to hold more than 10-15 stocks at any point in time.

The portfolio then is simply a basket of stocks that the trader carries into the next trading day.

Traders build their portfolios based on technical analysis or on the information that they receive from their brokers. Their choice of stocks is typically confined to the large-caps and active mid-caps.

The point is that such portfolios are not constructed to meet any specific investment objective. Rather, the portfolio is expected to generate short-term income, which is the primary source of revenue for some.

The concentrated portfolio then is expected to generate income in much the same way as an employee expects to receive salary from her employer.

It is for this reason that a concentrated portfolio cannot form part of the core portfolio; for a core portfolio is constructed to meet a certain investment objective, such as to pay a liability structure five years hence.

Besides, a concentrated portfolio is set up to generate excess returns (alpha returns) - the primary objective of a satellite portfolio.

This leads us to an important point — active traders should hold another portfolio called the passive core. But would self-directed investment be optimal for such a portfolio?

Index funds are the preferred choice for the passive core, as they provide low-cost beta exposure. There must, hence, be a compelling reason for a trader to choose self-directed investments over index funds.

One such reason could be that the trader has a view on all or some of the index constituents.

Suppose the trader believes that Reliance Industries is likely to underperform other index stocks over the next five years. She may then be averse to buying an index fund; for such a fund would have high exposure to Reliance.

Setting up a self-directed passive core would then make economic sense.

A trader will require Rs 13,000 to create a self-directed portfolio that contains one share each of 13 stocks from among the top 16 of the Nifty index.

Logically then, asset size of Rs 1 crore and above would be optimal to build a self-directed passive core; for a trader typically prefers to hold 750 to 1,000 shares of each stock.

The core-satellite portfolio framework can be applied to all investors including the active traders.

It is important that traders realise the need to create a passive core alongside their trading portfolios. Those having smaller asset size should consider index funds for the passive core.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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