Category: Investment Management

How to construct an ideal portfolio

How to construct an ideal portfolio

Starting with an essential emergency fund( cash reserve ) , then Insurances, Asset Allocation as per one’s risk profile, timely rebalancing of portfolio, Estate Planning etc. all  focus on risk management along with strategies to beat inflation and generate  decent returns to achieve financial goals. An important part of asset allocation includes investments in Equity, Debt  Cash and Gold.. However , picking the right mix of MFs requires guidance from a professional than a novice looking for a jackpot.


The best mutual fund scheme does not mean the best in returns, but the one best suited to your risk profile and goals and the one that is good in its peer group. The biggest mistake that mutual fund investors make is selecting mutual funds only on the basis of performance and that too just the recent performance.


There are some thumb rules to access a Mutual Fund :

Performance Ranking-

More than the recent or long term performance of any scheme its ranking among peers should be looked at  Ratio analysis Risk and return ratios like standard deviation, Sharpe ratio  along with Treynor ratios and Jensen’s alpha.Sharpe Ratio measures how well the fund has performed vis-a vis the risk taken by it. It is the excess return over risk-free return (usually return from treasury bills or government securities) divided by the standard deviation. The higher the Sharpe Ratio, the better the fund has performed in proportion to the risk taken by it. The Sharpe ratio is also known as Reward-to-Variability ratio and it is named after William Forsyth Sharpe.

The greater a portfolio’s Sharpe Ratio, the better its risk-adjusted performance. A negative Sharpe Ratio indicates that a risk-less asset would perform better than the security being analyzed. Ø This measurement is very useful to compare funds with similar returns or high returns, by analyzing the same in line with the risk taken. Ø Risk-adjusted financial performance of investment portfolios or mutual funds is typically measured by Sharpe’s ratio. From an investor’s point of view, the ratio describes how well the return of an investment compensates the investor for the risk he takes.


In the same way that the Sharpe ratio measures excess return per unit of total risk, or standard deviation, the Treynor ratio measures excess return per unit of market risk. The numerator of the Treynor ratio is the difference between the portfolio’s return and the risk-free rate. The denominator is the portfolio’s beta. The calculation for the Treynor ratio is identical to that of the Sharpe ratio except that beta instead of standard deviation is used in the denominator:

T= Portfolio returns – Avg risk free rate of return /  b ( of the portfolio)-

Beta is calculated as the covariance between the portfolio returns and the benchmark returns divided by the variance of the benchmark.  Betas greater than 1 or less than 1 indicate corresponding degrees of more or less sensitivity to market movements. A beta of zero does not signify a lack of volatility relative to the market but rather a lack of correlation with market volatility.

Jensen’s alpha, on the other hand, can be used in an absolute context; the existence and degree of manager skill are apparent by the sign and the size of the alpha. The Treynor ratio and Jensen’s alpha assess whether the manager was able to generate excess return for taking that risk.

  1. Total expense ratio- Expense ratio is very important parameter to be looked at while selecting any mutual fund scheme. All fund management and distribution related expenses are borne by the scheme. This means high expense ratio will affect the fund’s returns. Though mutual fund’s total expense ratio has been capped by SEBI, still lower the better unless we get some extraordinary return by paying higher expenses for fund management.
  1. Fund manager tenure and experience- Fund manager plays a very important role in the fund’s performance. Though it is a process oriented approach but still fund manager is the ultimate decision maker and his experience and view point counts a lot. You should know who is the fund manager of the scheme and what is his past track record. You should also look at the performance of other funds which he is managing. If the fund manager of the scheme has recently been changed, don’t panic.  Just keep a watch on his performance by looking at alpha and quarter to quarter performance. If you find that due to change in the fund manager there is considerable effect on the fund’s performance which does not suit your risk appetite then you may need to check with your financial advisor what is to be done.
  1. Scheme asset size- Asset Size plays a role in churning the portfolio, portfolio turnover costs and how well a fund manager is able to deliver returns to existing customerd without hampering growth or inflows into the scheme with fresh funds.Exit of any big investor out of any mutual fund may impact its overall performance very badly and the remaining investors in a scheme will have to bear the impact.  In schemes with larger AUMs this risk gets minimised.
  2. Portfolio construction- An ideal portfolio can be constructed based on risk appetite and the tenure of investment , returns expected and tax friendliness.

The research methodology followed by Dilzer Consultants in fund selection

Process Objective

The objective of this process would be to optimize the risk – return relationship for a given risk profile by applying scientific and proven methods of portfolio construction and management.

Steps followed in the Portfolio  Construction Process.

  • Asset Allocation
  • Fund Categorization
  • Fund Selection
  • Portfolio Optimization
  • Asset Allocation Methodology

We formulate a forward looking Asset Allocation Strategy, taking cues from Strategic and Tactical models.

The Asset Allocation would be based on 2 broad parameters-

  • Risk Profile of the Client
  • Market Dynamics

The strategic asset allocation would be revolved around the Risk Profile of the client while tactical allocations would be based on the Market Dynamics. To ascertain the allocation towards the tactical side, we will look at the Valuation & Momentum Metrics of the Equity Markets.

We use the following 5 data points to gauge the tactical modeling.

1 Trailing PE Ratios of Nifty 50.

2 Index values of Nifty 50.

3 Near month futures for Nifty 50.

4 FII Inflows

5 Volatility

All data points are dated back since 2000, except Volatility.

Appropriate statistical functions are used for the model optimization.

Fund Category Breakup

We view it as a subset of Asset Allocation and a precedent to our Fund Selection Process. This will also be based on the client’s Risk Profile and Market Dynamics, although at a subtle level. For Instance, Index and Large Cap funds within the Equity exposure for client’s whose risk tolerance is low. For Debt, it will more likely be accrual category instead of duration strategy. As the risk tolerance level goes up, the categorization will undergo a change.

Fund Selection Process

The table below explains the Research Methodology followed by us in choosing the funds.

Parameters Weightage (in %)
1 Year 5
3 Year CAGR 10
5 Year CAGR  
7 Year CAGR  
Standard Deviation 10
Sharpe Ratio 7.5
Sortino Ratio 7.5
Treynor Ratio 7.5
Information Ratio 7.5
Jensen’s Alpha 7.5
R-Squared 7.5
Negative Attributes  
Negative Count 10
Mean Return 10
Standard Deviation 10

Leading indicators such as YTM, Duration, Sector Exposure also may be used from time to time for refining the fund selection process.

Portfolio Optimization Process

Having chosen the recommended funds, the next step is to decide what percentage should go into a respective portfolio. There again, we use a scientific model viz Mean Variance Optimization. This model will identify portfolios that falls on the Efficient Frontier optimizing the Risk-Return relationship.

Portfolio Presentation

A portfolio fact sheet with the relevant underlying attributes in terms of Return, Risk and Portfolio will be released at a  regular frequency. The factsheet will also explain the return attribution, that is what percentage of the portfolio returns has come from Asset Allocation, Scheme Selection etc.

Sneha Ramamurthy

Dilzer Consultants Pvt Ltd