Strategies in passive investing

Last Updated: Sun, Dec 09, 2012 11:34 hrs
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There are many arguments in favour of passive investing. It is a convenient way to generate decent returns. An index-tracking portfolio of ETFs or index funds can be created easily through SIPs. The entire process can be automated and judgement is not required.

An active investor not only accepts more risk, he must also spend more time on decisions and strategy. One set of broad strategies revolve around buying the same stocks that populate the indices, but doing it in different weights and varying timing of acquisition.

Versions of the “high dividend yield” strategy are among the best-known. First, look at the lowest-risk version. Take exposure in an index ETF. Then pick the five index stocks with the highest current yields, based on the current price and last dividend payout. Buy these five stocks directly. Hold everything for a year, in order to receive dividends.

Chances are, this set of five stocks will beat the index over the next year. The high yield indicates a prior period of poor price performance. You hope the price trend will change and this set of five will rise more than the index. The high dividend yield is also a cushion for the returns, assuming payouts are maintained. There is some safety, since businesses in poor shape tend not to pay dividends. A year later, you can churn. Replace the biggest gainer (or gainers) in your set of five with the highest current yield you can find.

A combined portfolio of ETF plus five high-dividend stocks should give a performance superior to a 100 per cent ETF holding. How much of a difference will depend on several things. One is of course, the performance of the five stocks. Another is the relative weight of ETF versus the five in your portfolio. A third variable is the relative weights of the five versus each other. You should commit equal amounts as far as possible to these five stocks. You don't want to be underweight in the stock that has the best performance.

If you wish to detach your portfolio from index returns, buy only the five high-yield stocks and avoid the ETF. This method is higher-risk . But a 100 per cent commitment to five high dividend stocks could offer a much higher return as well. One multi-bagger in your set will be enough.

A variation of this involves reviewing more regularly. Every quarter, compare the set of five you hold, versus the latest set of five stocks with the highest current yields. Don't sell your holdings. You strategy depends on receiving the dividends. But if any new high-yield stocks are visible, buy those as well and keep equal weights.

This way, you build a portfolio that will look more like the index, as you gradually acquire more stocks. But your portfolio will perform differently. You have bought each stock when it was likely to be cheaper than normal and your weights are equal, unlike in the index.

A higher-risk method is to ignore dividends yield and just focus on the five stocks that have suffered the most capital loss (or the least gain) in the past year. If these five pay dividends, that's fine. But you are targeting pure capital gains.

The “five-loser”strategy can be implemented in conjunction with an ETF, or on its own. There may not be much cushion if these losers don't pay dividend. Weights should again be as close to equal as possible. If this strategy is reviewed every quarter, you will keep buying more stocks when they are relatively cheap. Again, this portfolio will eventually look more like the index. But it will have a different, and possibly superior, performance because the stocks are being bought post-correction.

These are simple strategies which may be implemented almost mechanically. There is little discretionary judgement required. You will only have to assess unusual situations that may have led to extraordinary dividend payouts, and price-drops caused by abnormal events like fraud.

Such strategies don't need daily monitoring. Even if you implement a quarterly rebalancing, it doesn't take much effort. However, each stock should be held for at least a year. The results will be lumpy since you're doing your buying at a specific price, rather than averaging like a SIP.

Backtesting and actual results from people who have tried these strategies suggest that the performances are, by and large, superior to passive index investing. But the returns are more variable and sometimes, huge underperformance results with the five-loser method.

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