However, through strategic and astute diversification, one can reduce the overall risk associated with an investment portfolio. In the words of Benjamin Graham, “There is a close logical connection between the concept of margin of safety and the principle of diversification.”
Portfolio diversification requires one to allocate the investments in the portfolio across multiple asset classes so that a sharp negative movement in any one asset class does not have a big impact on portfolio returns. This limits the risk exposure to a single asset class or security, and reduce the overall risk or volatility of the portfolio.
Achieving diversification through ETFs
- Market Capitalisation Based ETFs
Exchange traded funds (ETFs) can prove to be an attractive vehicle to diversify your portfolio. ETFs are a type of investment fund or basket of securities that are traded on the stock exchanges. Generally, most ETFs are index based; that is, they hold the same securities as a stock market or bond market index, and that too in the same proportion. By doing so, an index ETF aims to replicate the performance of the underlying index, i.e., generate returns similar to the underlying index.
For example, a Nifty50 Index ETF will hold all the Nifty50 stocks in the same proportion as the index. As a result, the fund will mirror the movements of the benchmark index. If Nifty50 goes up, the returns from the ETF will go up and vice versa. More importantly, the proportion of gains or losses on the ETF will also be more or less the same as the Nifty50 index. The small difference, if any, between index returns and ETFs returns can be attributed to tracking error.
A sector-based ETF is designed to track a particular sectoral index, for example: banking (PSU and/or private bank, IT etc.). Here, the entire portfolio will be concentrated on a single sector. So, if one has a strong view on a sector and is confident about its prospects then she can opt for a sectoral ETF.
Smart beta ETFs follow a rule-based investing approach by applying factors such as low volatility, alpha, value etc. while selecting stocks. As a result, the philosophy of investment remains passive, but the style of investment becomes rule-based, and thus, active. Hence, smart beta funds are considered a hybrid between active and passive investing. A smart beta ETF is one of the ways to invest in a fund with a superior risk-adjusted return due to its focus on specific stocks.
Debt ETF is at a very nascent stage in India. Currently, the ETF options are limited to liquid, gilt and PSU debt.
Gold ETF aims to track the price of domestic physical gold and invest in gold bullion. Gold ETFs invest in gold bullion, which is as good as investing in physical metal. It is held in electronic form, and an investor may buy as little as one unit. For anyone looking to accumulate gold for the long term, investing in gold ETFs could prove to be the easiest option. Remember, because of their unique structure, gold ETFs have much lower expenses compared with physical gold investments.
(Chintan Haria is
Head of Product Development & Strategy at ICICI Prudential AMC. Views are his ow)