How to build a permanent portfolio

This article was originally published in May 2021. We are updating and republishing it for the benefit of our newer subscribers.

The concept of a ‘permanent portfolio’ has been gaining interest in the past few years, likely driven by the influx of new investors in the market who are looking for zero or low maintenance investment solutions. The term itself has meant different things and these different meanings have varying degrees of ‘permanence’ about each of them. Whether a portfolio will be permanent about its fund choices or asset balance or allocation depends on the degree of effort that an investor is willing to put in and the returns expectations that they have.

In this article, let’s explore this concept in some detail. We will look at the merits of building a permanent portfolio and how you can build/own one, if you feel it is right for you.

Do you need a permanent portfolio?

A portfolio that you don’t have to monitor has many advantages. But it is not necessary that you have one. You need one only if you fit into any of these below:

1. You do not want to take the help of a fee-based advisor nor do you have the time to do your own homework to build and maintain your portfolio. 
2. You do not want the hassle of tracking fund performance and diligently weeding out poor performers and shifting to better ones, periodically. 
3. You do not want to deal with fund manager changes, fund closures, fund mergers, funds changing their objective/strategy, and funds suddenly shutting down without giving you notice! 
4. You do not want to be paying taxes every time to shuffle your portfolio.
5. You simply do not like the idea of paying higher cost (expense ratio) 
6. You believe active investing will lose to passive investing with time, if not already.
7. Importantly, you are not looking for ‘best returns’ and are happy with what the market delivers.

Is a permanent portfolio possible with active funds?

Many of you wish that we gave you a set of funds that you can hold forever. We wish we could too. Fund houses with a 20-25 year track record argue that their funds have delivered top notch performance over 20 years or more. Sadly, many such funds have languished in the performance charts in the last 5 years or more.

There are several reasons why a permanent portfolio is difficult to achieve with active funds. We have explained it in detail in an earlier article on why buy and hold is not a sound strategy with active MFs. But some of the common reasons why active funds find it hard to sustain performance over lengths of time is given below: 

• One, there can be a fund manager exit that triggers a dip. Even if the new fund manager tries to stabilize performance, the wide margin of underperformance with peers, by then, makes it hard to play catch up. We have seen this in funds like IDFC Premier Equity. 
• Two, fund managers take calls that go wrong or take a long time to perform. Those who reverse such calls quickly bounce back. Those that wait it out suffer. We have seen this in schemes of large fund houses such as Franklin India and HDFC Mutual when calls in banking or regulated sectors like telecom go wrong. Sometimes there is a belief (call it the gambler’s fallacy) that the bets that did not work will have to eventually work. This belief was not uncommon in PSU stocks. 
• Three, the size of a fund can grow unwieldy to a point of difficulty in deployment of inflows. We have seen this in yesteryear top performers like Nippon India (earlier Reliance) Growth, Nippon India Vision. They had to shrink before they grew again. This is also particularly true of mid and small-cap funds. Poor liquidity in the mid and small-cap segment means that funds cannot readily deploy the sums in one shot without impacting stock price. Likewise, they cannot exit at one shot, thus seeing a difference in the ‘book’ profits and ‘realized’ profits.
• Four, a fund can change its strategy either due to change in regulations or change due to its own internal rejig. For example, some midcap funds fitted themselves into the large & midcap space and others into flexicap space when SEBI’s new categories came 5 years ago. This not only alters your return expectations but also the fund’s risk profile in your portfolio. 
• Five, a changed market phase can bring an entirely new set of outperforming funds. The funds of pre-2008, never made the cut post 2008. Why? The strategy/theme that the fund rode in the previous decade did not repeat itself in the next decade. Funds that rode the infrastructure/cyclical themes underperformed in the post 2008 period as they could not readjust their portfolio in time for the next theme of defensives. It then becomes a case of too late to catch up. 

We are not suggesting that an active portfolio is bad. We are just stating that for all the above reasons having a “permanent” buy and hold portfolio with active funds is difficult.

A permanent portfolio with passive funds

A portfolio made of passive funds solves many of the problems stated above. There is no fund manager or strategy change and there is no such thing as managing a fund’s size. This is truer when the underlying funds/ETFs are market-cap based. You will never have a problem of a mid-cap index becoming a largecap since the marketcap-based strategy will ensure that the large-caps are removed and emerging ones are added.

However, when you build a permanent portfolio with passive funds, you need to get these two points right:

• You’re not building a passive permanent portfolio hoping it will beat all active funds. You’re choosing them to simply stay with the market. Staying with the market can mean beating active funds at times and underperforming them other times.
• When you wish to follow the market, market-cap based index investing is a more fool-proof strategy than adding smart-beta or factor investing funds. The latter, if used, adds an element of ‘active allocation strategy’ to your portfolio. In other words, if you add a low volatility or a value strategy, you may not always sail with the market. You may underperform it in some phases. You need to ensure you mix such indices with those that counter these themes if you want to ensure a portfolio that performs across markets. So, it is desirable that a majority of your permanent portfolio has market-cap based index funds to keep it a real low-maintenance portfolio.

How to build a permanent portfolio?

Step1: Asset allocation

 As is the case with most portfolios, a permanent portfolio too will need an initial asset allocation planning – choosing the right proportion of equity and debt fitting your time frame. You can take cues from our time-frame based portfolios (although the said portfolios are active) on how this can be done. Needless to say, when your time frame is less, your ability to take on equity funds will be reduced. Given below is a simple indicative table of what ranges your asset allocation can be at for different time frames. Do note that it is not a risk profiled allocation and should not be construed as advice. They are only broad indicators for you to build your portfolio. It does not also tell you if and when to rebalance.

Step 2: Index choices

The next thing would be the choice of funds itself under each asset class. 

Let’s take debt first. With debt, you have 3 broad options in the market today. Liquid ETFs, pure gilt ETFs/index funds/FoFs and PSU bonds and PSU bonds with state development loans. Most of them come with a matuirty although you can exit anytime. That means, you will have to choose one that fits your maturity. There are also more recently open ended funds with gilt and short duration SDLs, without a maturity.

All of these are either debt index funds or ETFs or FoFs. Depending on your time frame, you could mix and match these. You could simply keep it to liquid ETFs and not bother to deal with the volatility of the rest, if you plan on a simple portfolio.

Next, gold is available as ETFs or as gold funds. Gold can be a part of any long-term portfolio for the sake of diversification, if you do not already hold gold outside the fund route. Of course, you need to take cognizance of the minimum time frame you need to hold gold (see our asset allocation chart above). If you decide to add gold later, remember, it is not a substitute for debt. Reduce your equity component to add gold since gold is no longer a hedge in the sense of keeping volatility low. Gold has become highly volatile and helps you primarily in periods of poor equity performance.

In equities, the choices are a lot more now than it was 5 years ago. We have discussed in detail in this article on how to build a portfolio with index funds (or ETFs). But in this, how simple you want to keep it and how complex you wish to go entirely depends on your time, ability and desire for higher returns. So let us break this down into various options in the order of simple to complex portfolios.

Option 1 – Single equity index portfolio: Simply holding a truly representative market-cap based index is the simplest and true-to-label permanent portfolio. In this, your equity should not extend to anything beyond the Nifty 50 or Nifty 100. After all, they represent over 80% of the market cap and ensure you ‘stay with the market’. The ideal thing would be for you to mix this index with a liquid fund. This option is ideal for those who want a super-simple approach and specifically for those who want a small component of equity. For example – if you want to hold just 10-15%in equity for say a 3-year time frame, then you can keep your equity allocation simple with Nifty 50. 

Option 2 -Marketcap diversification: If you would like a little more diversification and enhance your returns, then your portfolio can be a mix of large cap, broad based (like the Nifty 500 or BSE 500), midcap and small-cap indices like the Midcap 150 or Smallcap 250.

Option 3- Add on indices: Indices that use various factors such as alpha, beta, value, low volatility or a combination of these are called factor indices or smart-beta indices. These indices bring in an element of management into your portfolio and increase ‘seasonality’ in performance. In other words, smart beta indices may underperform when broad markets outperform and vice-versa. For this reason, smart beta indices such as low volatility or alpha low volatility or value should not form a primary part of your portfolio. For example, if you have 70% in equities, then it is desirable to have least 50% in pure market-cap index-based funds. 

If you need more aggression, then thematic/sector passive funds are also available - right from banking, pharma, consumption, manufacturing to IT. However, if you decide to choose these, then there is an element of timing (both entry and exit) needed in indices that do not hold large-caps. FMCG, IT and Banking are typically large-cap oriented but can still be cyclical. So, many of these indices defeat the purpose of a permanent portfolio unless you hold small proportions in them and not seeing the need to time them actively.

Option 4 - Going international: To add further diversification or flavour, international funds can be considered. Keep it to passive investing here and keep it simple by sticking to US-focused options. Since the US markets are known to have relatively lower correlation with Indian markets and given that most other markets are less stable than the US, venturing into other markets will only increase the ‘active’ management component. You however need to make sure that you are able to identify a fund that accepts inflows given the continuing RBI restrictions on this front for international funds. ETFs though would be available.

We have summed up the above options here:

Step 3- Rebalancing

Now the all-important question of whether you should rebalance your portfolio – that is should you rejig your equity, debt or gold holdings periodically when one of them is inflated. This is a choice you can make. If you want utmost simplicity, then you can make this a true permanent portfolio without any kind of changes. That means even when your equity moves from, say, 70% to 80% of your portfolio, you will not rejig it and bring it to 70%. This is quite ok if you are holding the most simplified portfolio with say a large-cap index and a liquid index (option 1). But where your holding gets a little more complex, with say midcap indices or global indices, then reviewing your portfolio annually is desirable. You can simply stick to checking if the allocation to any of the asset classes has gone out of sync and bring them back to the original levels.

Our permanent portfolios

We have long-term permanent portfolios through index funds and ETFs. You can check them here under the head ‘passive investing’. You can alter this to reduce equity if your time frame is lower than the minimum 5-7 year period we have suggested. You can also keep it simple to just Nifty and liquid ETFs as suggested earlier. If you wish to build your own permanent portfolio, you can also check our passive funds in Prime Funds and also our recommended ETFs.