6B.13 Building a fund portfolio · M06B Funds and ETFs

Motivation

The previous sections give the pieces: costs compound, active returns are mostly noise, ETFs and index funds differ in trading costs, and debt funds are duration and credit bets. A portfolio is the decision that combines them.

An index core with satellites#

Core and satellites A low-cost broad index fund (or ETF) as the core of the equity allocation, chosen by tracking difference and cost (6B.8), and, if wanted, a small number of active or factor satellites, each with a reason that can be checked: a distinct strategy, high active share, a manager with a long record, and capacity left. M06 · 6.11 takes the same stance for direct stock-picking. M14 builds the overall asset allocation.

Fund overlap and blending#

How many funds? Diversification across funds is not diversification across stocks. Two diversified large-cap funds share most of their holdings. SEBI's 2026 overlap measure (6B.4) between portfolios with weights $w^A$ and $w^B$ is

O(A, B) = \sum_i \min\big(w^A_i,\, w^B_i\big), \tag{6B.32}

which is 1 for identical portfolios and 0 for disjoint ones, and equals $1 - \tfrac12\sum_i|w^A_i - w^B_i|$ , one minus the active share of one portfolio against the other (because $\min(a, b) = \frac12(a + b - |a - b|)$ and each weight vector sums to 1).

Proposition 6B.13.1blending active funds

Let $k$ active funds have the same benchmark, the same expense ratio $c$ , the same expected active return $\alpha$ before fees and the same tracking error $\sigma$ , with uncorrelated active returns. An equal-weight blend has expected active return $\alpha$ , expense ratio $c$ and tracking error $\sigma/\sqrt{k}$ . If a fund with active share $AS$ is viewed as $(1 - AS)$ of the index plus $AS$ of an active portfolio, and the index part could be bought at cost $c_I$ , the expense ratio implicitly paid for the active part (Miller 2007's "active expense ratio") is

c_A = \frac{c - (1 - AS)\,c_I}{AS}. \tag{6B.33}

Proof

The blend's active return is the average of the funds' active returns: its mean is $\alpha$ and, with zero correlations, its variance is $k\sigma^2/k^2 = \sigma^2/k$ . Its expense ratio is the average of equal expense ratios, $c$ . For (6B.33), equate the fund's cost to that of its two notional components, $c = (1 - AS)c_I + AS\,c_A$ , and solve.∎

Adding funds does not reduce the fee but does shrink the active bet that the fee pays for: a blend of many active funds converges to an expensive index fund. With the same holdings logic, (6B.33) prices the active part of a single fund: a fund with $c = 1.00\%$ and active share 0.40, against an index cost of 0.15%, charges $(1.00 - 0.09)/0.40 = 2.28\%$ a year for the 40% of the portfolio that differs from the index.

Rebalancing and decision rules#

Rebalancing Fix target weights (for example between equity, debt and gold), and rebalance when a weight drifts outside a band (say ±5 points) or once a year, preferably with new money or by switching inside tax-efficient limits, so as not to realise gains unnecessarily. Rebalancing sells what has risen and buys what has fallen: it controls risk; it is not a source of return (M14).

Decision rules

Direct or regular? Direct, unless you are paying for advice you value at more than the trail (Worked example 6B.3 prices the trail; Proposition 6B.5.2 prices it from the distributor's side). If you want advice, compare the trail over your horizon with a fixed advisory fee.
Index or active? Index for the core. Active only where (i) the category's evidence of net underperformance is weakest, (ii) active share is high and the active expense ratio (6B.33) is acceptable, and (iii) the fund's size leaves room to work (Proposition 6B.7.1).
ETF or index fund? By the crossover horizon (6B.27), with your actual ticket size, brokerage and holding period, and only for ETFs with tight spreads and open creations.
Which debt fund? Duration matched to the horizon; credit quality you can verify; a liquid or overnight fund for money you need within months (6B.10).
Which tax wrapper? Equity-oriented for long-term equity; arbitrage funds as a cash substitute only if your slab makes it worthwhile (Worked example 6B.16).

A pre-purchase checklist#

Checklist before buying a fund

What does it hold (SID asset-allocation table, last monthly portfolio), and is that what the name says?
What does it cost (TER of the plan you are buying; turnover; exit load), and what is its tracking difference if passive?
What is the benchmark TRI, and how has the fund done against it over full cycles, after costs, under this manager?
How large is it relative to its category's liquidity?
How is it taxed, and does the holding period you plan qualify for long-term treatment?
If an ETF: spread, depth, premium to iNAV, and whether creations are open.
If a debt fund: duration, YTM, credit mix, PRC cell, share of unlisted paper.
What does the person recommending it earn if you buy it?