Designing equity funds to meet life goals

Asset management companies (AMCs) are planning to introduce funds that intend to take exposure ranging from Internet of things to sustainable healthcare and cloud computing.

Yet, retail investors need investment products that can help them meet their life goals such as buying a house and taking an exotic vacation. In this article, we look at how an equity fund can be structured to enable investors to meet their life goals.

Risk-regret trade-off

Suppose you invest in a growth option of an equity fund because it is tax-efficient compared with the income distribution-cum-capital withdrawal option (previously called dividend option). The issue is that you are unsure of when to redeem your units and realise gains. This uncertainty exists even if you have a clear time horizon to achieve your goal. Suppose you invest to achieve a goal in 10 years. What if you have 30% unrealised gains on your investments in two years? Should you take profits or continue with your investments?

If you take profits and the market continues to move upward, you experience regret. Knowing that this is possible, you may want to avoid such regret today and, hence, decide against redeeming the units. But what if the market tanks? You could easily lose your unrealised gains. For instance, a 33% decline in your equity investments will wipe-out unrealised gains of 50%! That means you cannot accumulate large unrealised gains in your equity investments. And yet, you cannot redeem all your units in an equity fund. Why? If you do so, your investments cannot grow at a higher rate than bank deposits. And that means you cannot achieve your goal unless you increase your capital contribution! So, what should you do?

Rule-based profit-taking

The required return on your goal-based investment is a function of your savings, your asset allocation, the expected return on each of those asset classes, the time horizon for your goal and the amount required to achieve the goal. Typically, goal-based portfolios must have equity and bonds. Because your bond investments will be in fixed deposits, the expected return and actual return will be the same ignoring credit risk.

The expected return on equity is based on past returns experience, independent of your risk attitude and other factors mentioned above. This allows AMCs to create equity funds with simple profit-taking rule based on expected return.

Suppose the expected pre-tax return on equity is 12%.

An equity fund can be structured to take profits when returns are greater than the expected return of 12%.

So, if in any year unrealised gains in the fund is 14%, the fund should sell shares amounting to two percentage points (14% less 12%) of its total portfolio.

This profit-taking rule is based on the argument that you must risk so much capital as is required to achieve your goal. Therefore, the fund should retain 12% per annum unrealised gains in the portfolio; for this is the expected return on your equity investments, which, together with your bank deposits, should accumulate to the required amount to achieve your goal.

Enhanced index fund

AMCs could offer an enhanced index fund — a fund that will initially carry all the stocks in, say, the Nifty Index but take profits based on above-mentioned rule.

So, the fund is not positioned to mirror the index returns. It can, however, choose to take profits in such a way that its portfolio weights are closely aligned to the benchmark index after selling the assets.

The objective is to enable investors to improve their chances of achieving their goals; this depends on the actual return of the fund being equal to or greater than the expected return. Hence the need for a fund that is managed based on a transparent profit-taking rule.

(The writer offers training programmes for individuals to manage their personal investments)