My objective of investing in index based ETF is to have a total return that is somewhat similar to the market performance as a whole. It also acts as my benchmark for other long term portfolios. As mentioned in earlier post, if I cannot beat the market by stock selection, I should just close my long term portfolio and invest everything in these index ETFs.
My initial thought process was I would be investing upto 30% of my long term portfolio into index funds. However, after spending some time reading and understanding the various available funds, I have come to realize that there is not much choice available to individual investors. This is not to say, I do not like ETFs. I am still a fan of ETF assuming that they are structured properly and have reasonable expenses. In general, most of the ETFs have low liquidity and high expenses. I do not want my investments to get stuck in the low liquidity funds.
As of now, I will continue to remain under allocated to index ETFs. I do not know what be would the targeted allocation. I will let readers know when I make a decision.
I have initiated a starter position in NIFTYBeES ETF. I would like to invest in this fund based on certain criteria. A best aspect about index fund is that investor does not need to make a stock selection. As we all know, index consists of bunch of stocks based on their market capitalization. It will fluctuate and it will be volatile. As an index investor you will own all the stocks (in some percentage) in the index. The value of the holdings will follow the index. No need to make stock selection makes it easy for us to invest. The only thing we need to worry about now is “when to invest”. I do not want to blindly use a time-based systematic process because it is likely that I may be buying at historically high valuations.
I am an investor who is happy to keep cash in savings (or short term FDs) rather than buy at higher valuations. But the question that still remains to be answered is “what is the valuation for the index”? At what valuation will I be comfortable to buy my positions? Is there a way to determine index valuation? If there is a method, how easy or elaborate it will be? Assuming one can calculate the valuations, how effective it will be? With all these fundamental questions, it becomes little complex and time consuming to determine index valuation. Therefore, instead of going into all these aspects, I plan on using a metric known as “relative PE”. Relative PE is calculated as follows:
Relative PE = Current PE ratio of the NIFTY index] / [historical 10 year average PE]
Do not invest when relative PE is more than 1.0. Invest only when relative PE is less than 1.0. The actual amount invested is a function of relative PE. The chart below shows the plot of relative PE over time.
Let us take an example to understand this process better. I want to invest once a quarter. Consider I decide to put way Rs. 1000 monthly for index investment.
- Quarter 1: I accumulated Rs 3000 in three months waiting to be invested. If relative PE is 0.8, I buy 40% (Rs 1200) of my allocated investment. Rest I will continue to keep in cash.
- Quarter 2: I will have Rs 4800 (1800+3000). If relative PE is 0.5, I buy 100% (Rs 4800). If relative PE is 0.6, then I buy only 80% (Rs. 3840). Rest I keep it in cash.
- Quarter 3: repeat.
The advantage of this process is as follows:
- I am investing less when NIFTY is reaching closer to historical PE valuations. And I am investing more when NIFTY is going away from historical PE.
- I will have only four transaction fees in a year which is very much plausible than buying monthly.
- The most important is I will always have cash available to invest when it goes below historical valuations.
At this point in time, I do not plan to sell my index positions. This is because I am still in my wealth building and accumulation stage. The amount invested will be less. Over time, perhaps, in next 10 years or so, I will revisit and explore my exit strategy. Until then, it is only buying.
What are your thoughts? Do you use index investing with similar process?
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