The Hindu Business Line : Self-constructing an optimal education portfolio

Child education is an important component of any investor’s liability structure. This article discusses the child education plans available in the market. It explains why a self-constructed education portfolio with appropriate insurance cover would be more optimal within the core-satellite framework.

It is better to create a portfolio by yourself than depend on the ones available in the market.

B. Venkatesh

The market is filled with child education plans offered by insurance companies and mutual funds. Should investors buy such plans or can they construct their own education portfolio?

This article discusses the features of the products offered by insurance companies and mutual funds. It explains why a self-constructed portfolio within the core-satellite framework may be more optimal than the child plans on offer.

Education plans

Some insurance companies offer child education plans as unit-linked insurance plans. ICICI Prudential Smartkid New Unit-linked Regular Premium, for instance. The in-built insurance contract ensures that the sum-assured is paid if the parent (payer) dies. Others such as Tata AIG Life offer endowment policy.

This column dated August 2, 2009, discussed why it is optimal to separate investment and insurance decisions. One reason is that ULIPs typically carry front-load charges that can take away the advantages of compounding during the early years of investment. A separate term insurance policy and appropriate mutual fund investments are more optimal.

The second reason is that ULIPs do not offer the investment flexibility that investors require. That is, ULIPs often carry a diversified portfolio, which goes against the basic tenet of separating alpha (excess returns) and beta (market) exposure.

This is also the reason why child plans offered by mutual funds may not be optimal; for such plans invest in the same universe of stocks as diversified funds do. A self-constructed education portfolio may, hence, be worthwhile for the discerning investors.

Stock tilts

The objective of the portfolio is to fund the child’s college education. The portfolio will have to be liquidated when the child turns either 18 (to fund undergraduate programmes) or 21 (to fund graduate programmes). The investor should remember to cover the expected education cost through a term insurance policy. This ensures the child is guaranteed education despite the untimely demise of the parent.

The asset allocation policy is very important for such a portfolio. Suppose an investor constructs this portfolio when her child is 5 years old. The asset allocation policy will have stock tilt for two reasons.

One, education expenses rise with inflation. Traditional bonds are not inflation-protected, which makes stocks a better choice to hedge inflation. And two, higher returns in the earlier years would lead to higher compounding factor, translating into higher portfolio value at the horizon. This makes stocks a natural choice, as it could generate higher returns than bonds.

Typical asset allocation would be 75 per cent equity and 25 per cent bonds. The asset location policy would have bonds within the tax-advantaged sleeve and equity inside the taxable sleeve.

The portfolio has to be rebalanced, say, every 5 years to adjust for the risk vis-À-vis the investment horizon. The portfolio will typically carry bond tilts as the child reaches 18 or 21 years. This means that the rebalancing will essentially reduce stock exposure every 5 years. This shift in asset allocation is called the glide path.

A professional approach to asset allocation would require understanding of downside volatility (refer this column dated August 16, 2009) and the investor’s risk tolerance levels.

Suppose the initial investment is Rs one lakh constituting Rs 75,000 equity and Rs 25,000 public provident fund. The investor may have 70 per cent in core and 30 per cent in satellite portfolios. So, Rs 45,000 will be invested in index funds, which along with Rs 25,000 of PPF will form part of the passive core. The balance Rs 30,000 will be the satellite portfolio, constituting mid-cap/small-cap funds and style-specific funds to generate higher-than-benchmark returns.

Conclusion

Discerning investors can construct their own child education portfolio along with a term insurance policy to hedge mortality risk. Such a self-constructed portfolio can also strive to duration-match bonds with the education liability. An appropriate custom-tailored portfolio could be rewarding at the horizon.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

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