Building an Equity Mutual fund portfolio from scratch

In some of my blog posts this year, I have written about how one can build a Mutual fund portfolio with the new categories that SEBI has come up with. However, I still get a lot of enquiries on how investors, especially new ones, should go about building an MF portfolio. In this post let me show you how to build one from scratch.

Before we get into looking at the types a starting investor should invest in and what funds he can look at, let us first recap the types of equity funds SEBI has come up with.

  • Multi cap fund
  • Large cap fund
  • Large & Mid cap fund
  • Mid cap fund
  • Small cap fund
  • Dividend yield fund
  • Value fund / Contra fund
  • Focused fund
  • Sectoral/Thematic fund
  • ELSS

For an experienced investor all of these fund categories may have some use or the other in their portfolio. However, if you are at the starting point of your investment journey then my recommendation will be that you only look at 3 fundamental categories along with an ELSS fund for tax saving for the first 5 years or so. In fact, I will want you to forget the ELSS if you have enough money to invest in your MF portfolio and some good debt investment like PPF separately.

Ok, so without further ado, here are the fund types you need to have in your portfolio and some of the schemes which you can choose from.

  • Large cap fund
    • HDFC Top 100
    • ICICI Prudential Blue chip fund
    • ABSL Front Line Equity fund

 

  • Mid cap fund
    • HDFC Mid cap opportunities
    • Franklin Prima fund
    • DSP BR Mid cap fund

 

  • Small cap fund
    • DSP BR Small cap fund
    • Franklin India Smaller companies fund
    • HDFC Small cap fund
 Let us now see how you can create a portfolio from scratch. I will only outline the process here and if you are interested you can go through the various posts in my blog to get more details on the concepts and reasoning behind those.
  1. Based on your life goals, identify the time line for each major goal and understand how much of financial commitment they would require at those times. For example the college education of your son may need an amount of 40 lacs in 10 years.
  2. Once you know the time lines and the amounts, look up an SIP calculator and calculate the SIP amount you will need to invest every month. Use a return of 12 % to be on the conservative side. In the above example, to get 40 lacs in 10 years time at 12 % XIRR, you will need to do a monthly SIP of 17388 Rs.
  3. Do the above for all your goals and add up these amounts. This will give you the total monthly investment you need to do all your financial goals comfortably.
  4. Now look at your age to decide on your risk taking ability and therefore the ideal asset allocation. My suggestion will be the following :
    1. If you are less than 35 years old put 40 % in Mid cap funds, 35 % in Small cap funds and 25 % in Large cap funds.
    2. If you are between 35 and 45 years old put 30 % in Mid cap funds, 25 % in Small cap funds and 45 % in Large cap funds.
    3. If you are above 45 years old put 20 % in Mid cap funds, 20 % in Small cap funds and 60 % in Large cap funds.
  5. Once you have decided on the allocation, just pick out one fund out of each category and start investing. Do not worry about which fund as all of these are good and in the long run it does not really matter which one you have chosen. However, try to make sure that you have funds from at least 2 fund houses, preferably 3.
  6. A sample selection can be ICICI Prudential Blue chip for Large cap, HDFC Mid cap Opportunities for Mid cap and DSP BR Small cap fund for Small cap.
  7. Once you have decided on the monthly amounts, just set up an automated SIP and let the money get invested every month.
  8. You will need to do an annual review but that is a different story altogether.

I hope most people would have found this useful. Recently I was approached by a reader who wanted me to create a portfolio for him. I will share this in another post.

 
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Road to financial freedom for a fresh MBA

April is a month when the B school fever is at a peak, both for new admissions as well as for people who have just passed out and are about to embark on their first job. This year I got to meet quite a few of both varieties, courtesy my daughter’s convocation at XLRI and my being a panel member for the IIMC admissions. In one such interaction, I was asked a question – “how long will it take me to be financially independent, if my starting salary is 22 lacs a year and a good life today costs about 1 lac per month for a family?”.

I could not give a straight answer on the spot so I promised to get back to this person. If you look at it logically, we will need to make some assumptions in order to reach a conclusion on this. Let us go by the following :-

  • Rajat is 24 now and has an Educational loan of 20 lacs. He wants to pay it off in 10 years.
  • He is in a growth sector company and can at least expect a salary hike of 10 % each year. 
  • His initial costs per month will be 50000 Rs including 10000 Rs he sends to his parents.

Let us also assume that Rajat will live till 85 and will be financially free at age X. Based on what we had covered in the earlier posts, Rajat will need an income for (85-X) years. If he is assuming a cost per month of 1 lac in today’s prices, then it is reasonable to assume that at 6 % inflation, these costs will double in 12 years and triple in 20 years. Based on this Rajat will need 36(85-X) Rs as his corpus for zero real rate of return.

Putting some numbers in place now, let us see if Rajat can retire at 45 years:-

  • He will need to have 14.4 crores to fund himself till 85 years.
  • If he is investing in equity with SIP for 20 years, he will need to invest 1.45 lacs per month at a 12 % IRR. This is clearly not possible.
  • Viewing from another angle, how much can he invest today? Well, if he pays EMI of 25000 and has expenses of 50000 then he may be able to do SIP of 50000 at most.
  • In 20 years this will grow to nearly 5 crores @ 12 % returns.
  • With his increase in salary, Rajat will be able to do more SIP at a later date. Let us assume he will be able to do at least another SIP of 50000 Rs per month every 5 years. The new SIP’s will therefore be of 15,10 and 5 years respectively.
  • The new SIP’s will contribute the following to the corpus :-
    • 50000 for 15 years will grow to 2.5 crores @ 12 % returns
    • 100000 for 10 years will grow to 2.3 crores @ 12 % returns
    • 150000 for 5 years will grow to 1.22 crores @ 12 % returns
  • So from the MF route, Rajat will have about 11 crores.

Now apart from these he will also have substantial PF and some other Debt investments. Bottom line is he will easily be financially independent in 21 years time, if he is able to invest in a disciplined manner. As you have seen in the earlier posts, even with a corpus of about 12 crores or so, it will be quite easy to get this done.

I think the above will become the norm for the future very soon. We will have people working in regular corporate career for time periods of 20 to 25 years and then doing things which they are fond of. Of course, some may get off the train earlier so that they can follow something they are passionate about. 

Think of it – 45 and no worries financially any more that you have to earn money !! That is the stuff I always dreamed of but it took me another 5 years to get there.

Retirement corpus structuring – A Reader query

From time to time I get queries from my Blog readers that will resonate with the larger investor community. One such query was sent by a reader recently after he read my recent posts on retirement corpus structuring. I wanted to address it as a post here.

His query was as follows:-

Taking portfolio 1 as the base, if a person retiring this year from a private firm, has a house to live and corpus of around 2 crore in the following manner –
Debt portfolio – 50 lakhs in EPF, 10 lakhs gratuity, 20 lakhs PPF, 25 lakhs from LIC (maturing in 2022, premiums paid) and 10 lakhs in liquid funds/FDs for emergencies.
equity – 60 lakhs in Mutual funds and 25 lakhs in Shares. How should the corpus be structured to provide regular income in retirement, taking care of inflation?
Let me only try to do a structuring of corpus here as I have already explained the broad principles in the earlier posts. The assumptions are a current annual expenditure of 7 lacs per year, life expectancy is another 30 years and expenditure being double and 4 times in the next 2 decades respectively.
Without further ado, let me give my suggestions now :-
  • Take the 60 lacs from PF and gratuity and put in in Vaya Vandana Yojana and Senior Citizen Saving Scheme. This will have to be done by the investor and his spouse separately. This will give 4.8 lacs per year as interest.
  • Use 20 lacs PPF to withdraw 2.2 lacs every year for the first 10 years. Along with the interest, this will take care of the 7 lacs needed in the first decade.
  • When the LIC money becomes available, invest it in equity balanced funds. This will amount to 50 lacs by 2028, assuming a return of 12 % annually.
  • In decade 2 the average expenses will be 14 lacs. This will be funded through:-
    • 4.8 lacs will be available as before.
    • 50 lacs from Balanced fund will be redeemed @ 5 lacs per year.
    • 60 lacs MF will become 1.8 crores in 10 years with a return of 12 % annually. Take 40 lacs and put it in some hybrid fund such as MIP or Equity Savings Funds. 4.2 lacs each year can be used for the remainder of 14 lac expenditure.
  • In deccade 3 the average expenses will be 28 lacs. This will be funded through:-
    • Stocks which will reach a value of 1.93 crores in 20 years
    • MF which will reach a value of 4.34 crores in 10 years from 1.4 crores base.

So at the end of 3 decades the couple will still have some amount left, which can last them a few more years. It is highly improbable that they will live beyond 95 years, so it is a very safe plan.

I hope the plan addresses the issue at hand. In case there are any queries on this, I will be happy to address the same.

Some real life portfolios in retirement

In the several posts I have written on retirement here, I have tried to give both my personal examples as well as those of others. Many readers who are considering retirement want to know if the money they have as corpus will be enough. Some think they have adequate money but are not sure of how to deploy it optimally. In this post let me give 3 examples of real life portfolios from retired people.

Before getting into the actual portfolios, it will be important to understand the pre-requisites, in order to be able to go for retirement in financial terms. These are :-

  • You should have a place to live in. This can be either your own house or a rented one where you are covering the rent from what you get as rent of your house elsewhere. This is important as rent is inflationary and must be taken care of.
  • All your major life goals should be over. Even if some goals such as children’s marriage are pending, you have separate funds for those.
  • You have an ongoing Health insurance that you will continue with. Get this before you and your wife cross 50 years, they get very expensive afterwards.
  • Your children are taking care of themselves in terms of financial expenses.
  • You may still be earning some active income through use of your time but that is not considered in these portfolios.

Portfolio # 1:

This is the simplest portfolio I have seen with hardly any real risk and yet catering to almost any future eventuality.

  • Tax free bonds of 1 crore invested in 2013 with an interest rate of 9 %. This yields an income of 9 lacs every year till 2028.
  • PPF corpus of 40 lacs and contribution of 1.5 lacs every year till 2028. This will grow to more than 1 crore in 2028.
  • Emergency funds of 10 lacs in Liquid funds.
  • MF portfolio of 20 lacs and stock portfolio of 10 lacs now.

The couple have expenses of about 7 lacs per year and stay at their own home. They put 1.5 lacs in PPF every year and pay no taxes. In 2028 they can use the money from Tax free bond principal to invest in Debt or hybrid funds. At this time they will start using the PPF amount for the next 10 years. Note that this is also tax free. By 2038 their MF and stock portfolio should grow to 2 crores plus even with a modest return of 11 % or so. With another 2 crores from Debt funds they should have enough for the last phase of their life.

Portfolio #2:

This is slightly more complex as equity and debt are both used. Let us first see the deployment here and we will then look at withdrawal.

  • 1 crore in PPF as the couple were not salaried people and invested in PPF regularly over a long period.
  • 50 lacs in various types of Debt funds at current market value.
  • 40 lacs in equity MF and 10 lacs in stocks at current market value.

Assuming 30 years of retired life and an expense of 8 lacs per year in the first decade, this is how the couple have decided to go about it.

  • Withdraw from PPF to the tune of 10 lacs for the first 10 years. This will still leave enough money after 10 years in the account.
  • The 50 lacs Debt fund will grow to about 1.1 crores in 10 years. This along with the remaining amount in PPF will serve expenses of second decade.
  • The Equity portfolio of 50 lacs will grow to 3.36 crores in 20 years. This should see the couple through the third decade, even though the expenses by now are about 32 lacs per year.

Portfolio #3:

As a final portfolio, let us look into a more complex situation. Here, the resource base is larger and the expenses are also significantly higher. 

  • Two PPF accounts of 50 lacs and 10 lacs in current value.
  • Tax free bonds of 24 lacs, maturing in 2028
  • Equity Mutual funds of 50 lacs paying dividend of 3 lacs a year
  • Equity Mutual funds of 50 lacs with growth option
  • Stock portfolio of 1 crore with annual dividend of 3 lacs
  • Debt funds of 1 crore with LTCG of 8 lacs every year

Assuming the current decade expenses will be 12 lacs at an average, 15 lacs in the next decade and 25 lacs in the last one, how should things be structured?

  • Current passive income from interest and Dividends is 8 lacs. Another 8 lacs is from LTCG of Debt funds maturing every year.
  • In the first decade the PPF accounts will be funded to the tune of 3 lacs every year.
  • In decade 2, PPF can be used for withdrawal. The two accounts will suffice for these 10 years even without any fresh contributions.
  • For the last decade stocks and MF can be redeemed to fund expenses.

So there you have it – while 1.5 crores plus is quite enough for expenses of 8-9 lacs in a year, if you want to spend more then you should look at higher corpus. But the real lesson is in the deployment of corpus and withdrawal strategies.

Will be happy to answer questions on this.

Deploying Retirement corpus – a case study

This post is inspired through a discussion I had some time ago with a long time friend. He was considering to get out of his current corporate job and wanted to set up a passive income stream that would take care of his regular expenses. When I pointed him to my posts on this topic he said that, while he had read those posts and understood the situation from my context, he needed to set this up from scratch.

The discussion set me thinking and I wanted to look at a situation which many people may be facing when they are nearing retirement or are considering an early retirement. While generalization is always difficult, a typical situation of such a person may be as follows.

  • The person has an own home which is fully paid for by now.
  • He has a PPF account for a long time but has not contributed the maximum in a regular manner. Current balance in the account is 24 lacs (say).
  • His children are either independent or in college. In the latter case he has made arrangements for the remainder of their education expenses through FD etc. This is not linked to the passive income that he wants to have.
  • Fixed deposit amount is 20 lacs, PO MIS is 9 lacs in a joint account.
  • PF and gratuity will come to 1 crore when he withdraws it.
  • MF portfolio is 20 lacs and stock portfolio is 6 lacs.

Based on this, how should the money be deployed so as to get a passive income of about 7 lacs a year? There may be many ways but the framework suggested below is a good one:-

  • Keep the current MF and stock portfolio intact for the long term. You may need it for situations such as long term care, beyond the age of 80.
  • New investments in PPF are not needed but keep the account active by paying a small subscription every year. This is your fall back mechanism if you suddenly need money for some unforeseen event. Also the interest of 1.8 lacs a year is tax free.
  • 9 lacs of PO MIS will give an interest of 68400 every year. Use this for your income.
  • FD of 15 lacs can be put in Senior citizen scheme if you are eligible. The interest from this will be about 1.25 lacs.
  • Divide the 1 crore obtained from PF and gratuity as follows:
    • 30 lacs in tax free bonds. This will give you an income of 2.3 lacs per year.
    • 30 lacs in some dividend paying debt scheme such as Monthly Income Plan or Balanced funds. This will give you an income of 2.4 lacs odd.
    • 10 lacs in a Liquid fund. Income from this will be about 70000 a year.
    • Rest 30 lacs can be put in FMP or other Debt MF (short term) in the Growth option. After 3 years you can use the capital gain for consumption and reinvest the principal amount. This is mainly for discretionary expenses such as a vacation abroad etc.

What about inflation? Well, you have enough hedges in the plan for that. PPF can be drawn into, LTCG from FMP or debt funds are there and equity part will hopefully grow. Also over a period of time the 7 lacs needed in current terms may not suffer as much from inflation as we think. However, even if it does, the plan above is likely to cover it.

Note that the above is a low risk plan where your passive income is pretty much assured. Other options where you put more money into equity are possible but they come with a higher risk. You do want peace of mind when you are at this stage in life!!

So with an overall asset base of 1.79 crore (plus house), you can comfortably generate a passive income of 7 lacs and take care of the future also. I hope this convinces people that you do not necessarily need 5-6 crores to have a decent retired life. More importantly, you can lead the life you need to lead at the right time for yourself and your family.

An asset base of even 1.5 crores, deployed creatively, may well be enough for this person to retire. Take this framework as a reference and arrive at your own plans for that.

Cash flows in retirement – A personal perspective

In a previous post, I had outlined about the 3 decades in retirement and how one could have a simple framework to explain the dynamics of how they will be lived. The first one is the Go-Go decade where you try to fulfil many aspirations you had over the years gone by, the second is the Slow-Go decade where you still do many of your activities but on a significantly reduced scale and the final one is the No-Go decade where you are virtually winding down and kind of waiting for the inevitable end. Of course, this is assuming you are retiring in your 50’s and will need to be expanded in case you retire earlier. 

In the Indian context, however, this framework will work quite well as most people do retire in their 50’s and, despite medical advances, few live to be beyond 90. Once you have understood the framework, it will be fairly easy to outline how these decades will go in terms of your life activities and plan out your cash flows for the same. Understand that this is an individual exercise and cannot be reduced to formulae and calculators !!

When I started to look at my situation in the Go-Go decade in terms of my life, this is what I came up with. Some of it is, of course, not completely certain but it seems very likely to me that things are very likely to pan out as I write them here:-

  • I will still be actively engaged in professional activities in the first half of the decade but it will taper down over the next part.
  • Both my children will be relatively settled in their careers at the start of the decade and are likely to get married within it.
  • I am fortunate that my parents are living and in reasonably good health. However, another 10 years will be probably too much to hope for.
  • We will definitely shift from Hyderabad to Kolkata in this period, quite possibly in the next year or so. It is possible we will buy an apartment in Kolkata unless we get very good renting option.
  • As both Lipi and I love travel and we have time now, this decade is likely to see a lot of it. I estimate 1 trip out of India annually apart from another 3 within the country.  Most of these will have the two of us, hopefully there will be some family vacations too.
  • Our other lifestyle choices like entertainment, dining out, engaging in our hobbies will probably remain the same as it is now.
  • Both Lipi and I will probably engage in some non-commercial activities which are beneficial to the society at large.

What will be the cash flow impact of the above? I looked at my present context and tried to look at all categories of cash outflow at current prices. I am assuming that the first decade starts in 2019 and ends in 2028 – calendar years both, for simplicity. I will estimate cash flows in terms of Retirement Units ( RU ), as I am not very comfortable providing actual numbers. Intelligent readers should have no difficulty in figuring out the Rupee value of each RU !!

Here is how I divided up my cash outflow categories and estimates of amounts:-

  • Monthly recurring costs : This head includes everything that happens monthly namely food, groceries, eating out, entertainment, parental support, utility bills, subscriptions and maintenance etc. In the present context we spend about 5000 RU annually here and it will remain the same.
  • Accommodation : Presently our rent in Hyderabad is annually at 2500 RU. This gets taken care by the rent we receive from our Chennai apartment. We may buy something in Kolkata if we sell that.
  • Travel : in 2017 our spending on this was about 4000 RU. With increased travel I am estimating this to be 5000 RU annually for the first decade.
  • Emergency kitty : I am estimating this to be 2500 RU annually.

So in the first decade we are looking at annual cash outflow of 14000 RU. As long as our passive income generates this kind of cash inflow we should be fine. Let us then take a look at the same. My idea here is to generate these amounts from the Debt side as I want my equity investments to grow for the next decade. Of course, dividends are welcome. I am expecting cash inflow from these avenues :-

  • Rent from Chennai Apartment – 3000 RU
  • Interest from tax free bonds and InvIT – 2500 RU
  • Dividends from MF schemes – 2000 RU
  • Capital gains from FMP – 5000 RU
  • Dividends from stocks – 1500 RU

So with the above inflows I should be able to meet the needs without really having to redeem the principal amounts in most cases. From a financial asset standpoint there are a few things I am not using in this plan. They are as follows:-

  • Entire stock and MF portfolio which is 60 % of my net worth.
  • PPF interest – currently it will have an annual value of 3500 RU
  • POMIS interest – it is only 600 RU and can be used for minor emergencies
  • Any active income – difficult to put a value but for the next few years it should be in the range of 10000 RU and more. The plan is to use it for children’s marriage cost.

Based on all of these, I feel quite well covered for the next decade. Yes, we do not know what all can happen but so far so good. What about the next 2 decades? Well, with my equity portfolio growing at a faster pace that inflation, I do not think there is really a need to worry about them. 

If you are in retirement or are going to be retired shortly, try to work out your figures based on this post. You will gain a lot of confidence from it, assuming of course you are invested in the right manner.

Investment themes in 2018 you must look at

Investors who bet on equity in the last year have been exceptionally rewarded. The returns from equity asset class were stellar and there were no real corrections of note during the period. On the other hand debt returns were rather muted for almost all categories. One interesting note is that the bond yields have been rising steadily in the latter part of the year and is now at 7.33 % for the 10 year. Gold and Real estate did not fare well too and crypto-currencies were spectacular though a tad dubious.

Before getting into the themes for 2018, let us look at some basic numbers for 2017 :-

  • SIP in MF have gone from strength to strength during the year, rising by 50 %, and is now at nearly 6000 crores per month. This has amply compensated for the lack of FII buying and has ensured great liquidity at all times.
  • Equity returns in different categories were as below:
    • Sensex rose by 27.9 % during the year.
    • BSE 500 rose by 35.9 % during the year.
    • Large cap funds rose by 32.5 % during the year.
    • Mid cap funds rose by 45.6 % during the year.
    • Small cap funds rose by 57.9 % during the year.
  • Debt returns were muted and a prospect of hardening interest rates loomed:
    • Fixed deposit returns were in the 7 % range at the maximum.
    • PPF was at 7.8 %
    • Short term debt funds were at 6.4 %
    • Medium term debt funds were at 5.2 %
    • Long term Gilt funds did the worst at 2.5 %
  • Gold returns were poor too. Gold bonds were at 6.04 %, Gold ETF’s at 3.76 % and Gold funds even lower at 3.08 %. Buying physical Gold would be better as it rose by 7.13 % during the year.
  • Real Estate prices were disappointing with Bangalore being the best at 8 % and Delhi/NCR the worst at a negative 6 %. Most other cities were in the range of 2-3 %.

With this backdrop, what should be the themes of investment in 2018? Let us look at the prospects of different asset classes and that will help us to frame our themes.

  • Equity will have a significantly muted year as compared to the previous one. However, it is expected to be around 10 % returns and this will push Nifty to about 11500 or so by the end of 2018.
  • Long term bond funds gave very poor returns in 2017, but current high yields mean 2018 could be better. If the bond yields go up to 7.5 % then getting returns of around 9 % in some debt funds could be a reality.
  • Gold can go up somewhat in 2018 as compared to the past few years, where it had clearly under-performed. Expect a return of about 8 % if things go normally.
  • RERA, note ban and oversupply in the popular markets will mean that realty will again do badly in 2018. Prices are likely to remain stable with very low returns.

So with all of these in place, what should be your investment themes in 2018? Follow the guidelines below to arrive at your own decisions :-

  • Asset allocation – look at equity once more with probably 60-70 %, Debt can form the rest of it, Gold only for own needs and RE to be avoided.
  • Within equity, look at large cap MF more as the returns from mid and small cap funds can only go down from last year.
  • Multi cap funds and Dynamic asset allocation funds can be good choices this year.
  • Invest in short term debt schemes with low duration if you can hold for 3 years.
  • Arbitrage funds and Dynamic bond funds could be an option too.
  • If you must invest in Gold then do it through Gold bonds.
  • Avoid Bitcoins and the like, they are wholly speculative.

With the above themes in place what are some of the specifics that most investors will be interested in? I will cover those in the next post.