The following discussion is food for thought. In this article, we discuss how asset management companies (AMCs) can nudge their index fund investors for good.

Rule-based profit taking

In a core-satellite framework, the core portfolio represents your goal-based investments, and the satellite portfolio refers to your trading account. The optimal way to create your core portfolio is to invest in passive funds for equity allocation and bank deposits for your bond allocation.

Now, consider your investments in passive funds. You may have to rebalance your portfolio annually. This is to reduce the risk of losing unrealised gains on your equity investments. But you cannot take out the entire gains because your returns must be allowed to compound annually to achieve a goal. Suppose you expect 12 per cent annual pre-tax return on equity, you must leave 12 per cent unrealised gains on your investments. But you can take out gains that are more than 12 per cent in any year. This requires you to sell your ETF units or redeem units in your index fund.

That is easier said than done. You must manually redeem the units to take profits. Many individuals may fail to do so for various reasons. For one, you may forget to do it due to work-related pressure. For another, strong inertia will prompt you to postpone the decision to take profits. Research in behavioural finance shows that a simple nudge can go a long way in helping individuals take the necessary action. So, why not have the AMC nudge the investors to redeem the units annually when unrealized gains in the fund is more than a pre-determined threshold? Note that the redemption will attract taxes and may have to be a deliberate decision. Also, note that the redemption proceeds must preferably be invested in a bank fixed deposit. The fixed deposit can be withdrawn, and the amount reinvested in equity during years when unrealised gains from the fund is lower than the pre-tax expected return.

Conclusion

The nudge an AMC designs should inform each investor how many units they should redeem in the index fund based on a pre-determined annual threshold. This requires a simple arithmetic that a program can easily handle based on an investor’s account details. True, suggesting investors to redeem may not be financially optimal for an AMC, as it reduces their AUM. But the action may foster long-term goodwill; for the AMC would have nudged their investors for good.

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

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