Model Portfolio

How do we create an efficient portfolio. In my earlier post I had discussed on replication of mutual funds using ETF and also on replication of Index using options. Today I will combine all the features to create a portfolio .

We take the following assumptions:

Life insurance and Health insurance has been take care of.

Person has 3000000 INR to invest and he has monthly cashflow of 50000 to invest.


Whenever we start investing we take into consideration our liquidity requirement and tenor  we expect to  redeem our money.

Let’s say the person has 15 year horizon and needs  5000000 after 3 years.How do he go about investing.

Step 1: First we take care of the immediate requirement i.e 3 years. We will  put money in asset which will give us the 500000 in 3 year with high probability.We rule out equity and long term bonds.We choose Corporate debt fund  we put around 400000 which will grow to 5lakh in 3 years after  indexation benefit.

Step 2: Immediate liquidity: Its important you should have some money to meet any contingency.We put 1lakh in DBS bank saving bank account which give 7% and our return upto 10000 are tax free.

Step3: We might need some money between 1-3 years. We put that money in arbitrage fund,say 2 lakh for any requirement in between 1-3 year.

Step 4: We put 1-2 lakh in good P2P platform which will generate 13-15% return in form of EMI.

Step 5: Now we are left with around 30 lakh and 50k monthly cashlfow. Now we can invest in equity and long term debt.

why long term debt?  because yield is already touching 8% and will marginally go up but incase of market crash government will reduce interest rates and we can cover some stock losses.Best way to invest in long term bond is through SIP.

Of the 30 lakh lets say somebody wants equity exposure. Best way is to use options to synthetically replicate payoff.

So you buy  call option worth 90000 which will give you 30 lakh exposure. Now put 29 lakh in High yield corporate 29 Lakh will give 2.5 lakh in a year. So we are able to generate some yield ,get principal protection and also equity exposure.

If someone doesnt want equity exposure then put 30 lakh in arbitrage fund and start STP to mutual fund  after 1 year.(assumed that money was parked in saving till now and no tax benefit)

For the SIP part:

Lets say you want 30% large cap 40% mid cap and 30% small cap exposure.

Buy Nifty ETF,Nifty next 50 ETF  monthly and 2-3 small cap fund which have non overlapping portfolio.

How do we invest in ETF:

If we want to invest 20000 in Nifty every month.If market cracks in a day buy that day.If not then dont. At the end of month invest whatever is left for the month.

Is nifty 50,next 50,small cap index trading higher than average rolling return.If yes then dont increase  monthly SIP amount .If trading below increase SIP by 5-10% .How you get the extra money. Remember you have P2P account paying you monthly EMI .You have to choose between reinvestment to P2P and MF SIP.

Put around 5-10% SIP amount in long term gilt to build up a long term bond portfolio at high yield.

When portfolio has grown  big .Replace the Nifty part with options again and get principal protection!






Best Equity Derivative Trading Books

Equity Derivative Trading is  a vast subject and  with so much of information available these days on internet it can be overwhelming at times to pick up the right content.  I have tried to list down few books which I found very helpful.I am listing in the order they should be read in order to gain most from them:

  1.  Option ,Futures and Other Derivatives by John Hull: As Cliche as it may sound this is the book to start learning about derivatives in general.It will touch upon   different kind of derivatives,the  process of pricing ,the basic strategies.It deals with mostly theoretical concepts but not actual trading problems and  hedging nuisances.
  2. Trading Option Greeks by  Dan Passarelli: This books talks about the various greeks i.e. delta ,gamma etc and how we can use to manage our position using them .It has lot of examples to go with the theory and is more  oriented towards trading. The good part is that book is quite simple to absorb and someone with basic maths knowledge will be able to go through it.
  3. Option Volatility and Pricing by Sheldon Natenberg : Lot of stuff if you want to understand how each stategy is affected by multiple factors like volatility and time.Also it discusses the risk in each strategy at a very granluar level.After going through this book it is expected that you would understand the  risk ,reward and  problems for  most strategy.

The books we have covered till now help us to create a solid base in equity derivative. The next few books will help us to create a process for trading and risk management

  1. Option traders hedge Fund by Dennis Chan ,Mark Sebastian: It contains a step by step guideline to set up your                    own trading system.It also  has actual trading problems and solutions. It also covers how and when to enter some              strategy when is the right time to get out,how to set loss limits
  2. .Volatility Trading by Euan Sinclair: This book is mostly oriented towards professional traders as it has some really             good mathematical  methods  to  calculate  and forecast volatility for pricing . Mathematics behind ideal  way to delta         hedge, do your money management.All the factors which will really count for a someone who is trading at a high level.
  3. Option Trading  The Hidden Reality by Charles Cottle: Last but not the least. Reading this book  will give you a                     completely new way to look at each  strategy.How you can slice and dice each position.How to convert one strategy to     another. It  also dwells upon ways to  get in and out of position in most efficient way. The biggest takeway from this          book is how  you can have multiple position and still break it down to simple positions to  understand your actual risk   and reward.Though this book is slightly difficult and some parts might be confusing for a beginner but its worth the read.

Notable Mention:

Dynamic hedging By  NassimTaleb: This book is more relevant for risk managers.It covers lot of exotic options also  so it might not be very relevant for a retail Trader but if someone wants to know the nitty gritties of risk management for a exotic option book this book is very helpful.

Bible of Option Strategies by Guy Cohen:As the name suggest here you will find description of almost all the major option strategies ,payoff diagram and greeks for them.Good book for a quick reference on any particular strategy you want to deploy.


Bottom Line: These books will help you to accumulate all the knowledge you need to have for equity derivative trading but  it is paramount that you start trading alongside to really understand the intricacies .


Synthetic Replication of Portfolio

One major detractor for mutual fund is fees.Lets say somebody has been very disciplined in investing in mutual Funds for years .He made decent money and now his portfolio value is  50 Lakh INR.What would happen if the market does not move for the next 5 years.

average Expense ratio = 1.5%

Portfolio Value = 5000000

Loss = 3.64 Lakhs

Thats a substantial Loss .Why is the mutual fund making money when I am Losing

Another point is when the portfolio becomes huge market movement impacts the portfolio profit immensely!Doing SIP is great but anyway you going to lose money on existing portfolio:

Eg:Your Portfolio is worth 10 lakh and you doing 10000 INR SIP evry month.If market Crack 10% you are going to lose 10% networth.Period!!

Maybe you made good profit in the past at some good rate of return but who like to see the current value eroded?

Is there a solution ??

Yes ,The solution is synthetic replication.Its a method to replace your current portfolio with a strategy which can provide better risk return reward!!!

I have  reiterated benefits of ETFs of Mutual Funds many time.Now Let’s say someone has been investing in Nifty ETF through SIP and has a 800000 INR position over a period of time. I will demsonstrate how he can change his risk profile:

Scenario 1:

Person wants exact payoff as holding 800000 worth of Nifty 50 ETF.

Step1: Sell Nifty 50 ETF

Step 2: Buy ATM call ,sell ATM put for December expiry

We can see when market was trading at 10840  Call price = 361 ,Put Price =360

Our total exposure is 10840 * 75 (Lot size) =813750

So if we Do the postion we have zero upfront cost and  return exactly like our underlying position .

Now see the benefit:

We had to put 60000 as margin for the position .We are left with  813750-60000.

Now we put that money in high yielding debt fund .eg corporate Opportunity Fund etc.

Average Return is 8.5%

Till December interest earned = 8.5% * 180/365 * 750000 = 31875.

We have made 31875 extra with same  market risk as our cash position.

P&L for a 800000 Portfolio in 6 months

Scenario 2:

Person wants all the upside but choose principal protection

Step1: Sell Nifty 50 ETF

Step 2: Buy ATM call , for December expiry

We can see when market was trading at 10840  Call price = 361

Cost for 75 call lot = 361*75 =27075

Our total exposure is 10840 * 75 (Lot size) =813750

So if we Do the postion we have zero upfront cost and  return exactly like our underlying position .

Till December interest earned = 8.5% * 180/365 * 750000 = 31875.

We have made( 31875 –  27075 )extra with same  principal Protection.

This is just 6 months return .Just imagine doing this year on year with bigger portfolio!!

This is just couple of replication I have shown .We can adjust our option position preiodically to get more yield. Add a bit a P2P

etc to gain higher yield extra.

The bottom line is we are able to control our market risk plus get extra income.Its like buying a Mutual Fund and  getting paid with Expense Ratio

Real Estate vs SIP

The answer is .It depends!!

Real ESTATE vs SIP is a question of CAGR vs XIRR .In real estate you put lumpsum ,so even at lower annual rate you make more money .In SIP you put in multiple periods so though higher rate but lower money

lets say you want to buy a 1 Crore home.

You pay 10% from pocket and 90% loan .

SO total investment is 10 lakh and 90 Lakh is borrowed money

Now if you stay in that house you save some rent .Lets say at 25000 Per month i.e 300000 a year. which is 3% of total value of investment.

EMI for 10 years at 8.4% is 111106

Rent generate per month is 25000

Net actual EMI = 111106–25000 = 86106

So now what is the effective cost of loan where I have to pay 86106 EMI on 90lakh

answer is 3% !!!!!!!!!!!

why so low..?? My cost of fund is just 3 % why because I am getting rent on property of 1 cr while paying loan on reducing balance of 90 lakh I have borrowed . SO effective interest cost is 3%.

So in 10 year time what do my return look like:

Initial capital = 10 lakh

Total EMI = 1 .33 crore (EMI on 90 lakh)

Rent benefit = 40 lakh( assuming initial rent was 25k .in 10 years it grew to 35k)

So total investment = 1 crore approx

Initial house price grows by 7% then return is 2crore 6 lakh

What about stocks:

Total investment is

Initial capital = 10 lakh

Total SIP – RENT for 10 years at 86000 per month = 93 lakh

Profit from SIP at 12% annual rate = 2 crore 6 lakh

Initial 10 lakh also gives 30 lakh.

Net Money = 2 Crore 36 lakh

So a 7.5% growth in real estate is equal to 12% annual rate in market through SIP

So it depends:

  • Real estate will beat stock market due to leverage effect ( capital and rental yield) if it appreciates more than 7% a year but will lose if market stagnates
  • Basically in SIP you are investing in periods so your rate may look high but capital appreciation is less compared to lumpsum in Real estate
  • You save on tax exemption but again house maintenance cost money.
  • Important factor is higher interest rate will increase the breakeven rate for real estate.
  • Technically if i borrow 50% loan at 8.4% at reducing balance im paying 4.2% on rs 100 but I am getting 3% flat (rent)interest on 100 which is equal to 5.46%. I am actually making money even with a loan without capital appreciation !!!
  • Their are idiosyncratic risk with real estate like liquidity premium etc. which I am not touching

Real Estate vs Stock Market

Its much debated battle and people on both sides of the argument  have their own rationales and logic.Real Estate being an illiquid asset makes it  difficult to compare in a transparent and a fair way. I will try to do  backtesting of real estate performance vis a vis stock market.

 Real Estate data

I  got some residential property prices  for Mumbai for 2007 from newspaper excerpt. I want to ensure I dont take word of mouth but rather rely on evidence.


So From the old news articles I am able to get the approximate rent and real estate price in Mumbai during 2007 . I will compare price movement of 3-4  places.Now i need  see how the home loan rates have changed . I will take SBI home loan rate historical record for that .


  • Will take average property and rent for the area
  • Will assume rent growth is linear
  • Person stays in property and immediate possession

Based on the Rents prevailing in 2007 and home loan rate I calculated rental yield and fund cost trend.

Cost of funds is the actual interest he had to pay  which is the net of EMI he has to pay and rent which he saved thus an inflow

As we can see cost of fund has almost been same even though rates have gone down.As EMI and rent are both  monthly cash flow we can  net them to get a ball park figure. What inference we can draw from this ?

The home owner was able to borrow at an effective rate which is much lower than Home loan rate.

Lets compare CAGR for Real estate and Nifty Total Return Index over the period:

We can see prices for small underdeveloped  places  appreciated more compared to developed places

Now lets compare   2 scenario

  • Person  invest from own money
  • Person borrows 90% money

*Tax benefit on interest is not factored which will also  increase return

It is evident that in Real Estate we make  more money if we borrow money and real estate appreciation rate is higher than

our  cost of funds i.e Home Loan Rate – rental yield generated

Obviously we can lose money in the same way.Back of the hand calculation for real estate required return

Real Estate CAGR = Leverage *( Real Estate Return – Cost of Fund)

in this example = 10* (10*- (9%-3%) ) =40%

Final Verdict:

  •  As interest Rates are increasing we should be wary of the growing cost of fund.It could move to 7%+
  • 10X leverage is very dangerous (high return high risk),Maybe 3X leverage is good enough
  • Use optimum loan to maximize tax saving through interest also
  • Try to look for underdeveloped property as they are like small cap ,give higher value in the long run.
  • we need to subtract atleast 3% from stock market return to compare against Real Estate Return as we need to factor in rental yield we earn in real estate which is not possible in Stocks.
  • You can not leverage in stock market as you can do in Real estate as cost of fund will be 11-12% because its unsecured lending.
  • There are other factors like emotional value etc  in owning house which cannot be quantified