If you want to be conservative and invest only in bank deposits, then your ought to save more, as deposits earn lower post-tax returns. You must, therefore, invest in equity. True, equity has a downside. But that is the trade-off you must make to have a good current lifestyle and save for the future. Your equity investments must preferably be in exchange-traded funds (ETFs) or mutual funds. The question is: What benchmark should you choose? In this article, we discuss why funds benchmarked to a sector index or a strategy index may not be appropriate for your goal-based portfolios, and why your optimal choice must be a broad-based index or a large-cap index.

In the context of goal-based portfolios, your equity investment is a bet on equity as an asset class. That is, you are betting that equity investments will generate greater returns than the returns on your bond investments (read bank deposits). Your objective is not to bet on an individual sector performing well. Why? Each of your life goal will span multiple years. And it is highly unlikely that a sector that performs well today will do well next year or two years hence. Can you confidently shift your investments continually between sectors through your investing life? It is difficult to time the market. Therefore, choosing sector funds may not be optimal for goal-based investments.

What about funds based on strategy indices? These funds form part of alternative investments. The indices are created applying similar rules that portfolio managers use to generate alpha (greater returns than the benchmark index) in the traditional asset management space. In the U.S., the asset management industry typically offers ETFs on strategy indices. As the ETFs are typically passive products, ETFs on strategy indices are called smart beta products to differentiate them from ETFs on traditional market-capitalisation-based indices. Such products are yet to catch on in India. The point is that such products may not fit with the core principle of equity investment for goal-based portfolios- bet on equity as an asset class. Given our objective to bet on equity as an asset class, the preferred investment must be an ETF or an index fund on a broad-market index such as the NSE 500. Note that this logic applies to whichever markets you invest. The next preferred choice, if funds on a broad-based index are unavailable, is to invest in a fund benchmarked to a large-cap index.

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

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