All Weather Investing

Exchange Traded Funds (ETFs) as a concept has gained a lot of ground in the Indian markets over the past couple of years. The advanced infrastructure of ETF based investing in the Western markets have nudged our market participants to adopt it too. 

For the uninitiated, ETFs are financial instruments (read: basket) that track a particular index, commodity, or a group of stocks. It trades on the exchange – just like stocks. For example, the Nifty Index consists of 50 stocks. So if one wants to invest in the Nifty index, one can just buy the Nifty ETF, instead of buying all the 50 stocks in the same proportion as the Index. If the Nifty generates a return of 5%, the Nifty ETF will also generate approximately the same returns. Similarly, investing in a gold ETF will allow investors to earn the returns of investing in physical gold. As logic would guide, the price movement of a concerned ETF would be similar to the price movements of the underlying security or group of securities. 

Now, there are multiple reasons attached to the traction in the ETF space, let me outline a few here –

• Low cost investing – ETF instruments are passively managed vehicles, as they follow a certain index or theme, and hence the need to take calls on selective companies does not arise. Because of this passive nature of maintenance, they do not warrant frequent churn (churn refers to change in the portfolio of stocks due to frequent buying and selling) and thereby cut down on the transaction costs, which in turn makes them less expensive and low cost instrument as compared to an actively managed mutual fund or an actively managed portfolio of stocks. For example, if we have exposure towards 5 different stocks, specific calls need to be made on individual businesses. This cost efficiency on account of lower expense ratio helps ETFs take the title of low cost investment products.
• Diversification & risk element – The structure of the product is such that it offers rich diversification within the same asset class. This diversification primarily comes from a sectoral point of view, where stocks belonging to varied industries are pooled into a single ETF. We shall talk about this in greater detail, going forward, with a specific case in point. As a result, ETFs have a lower risk-element attached to it as the risk-reward is highly favourable for any investor. The reason being that with a modest capital disbursement one gets exposed to a variety of quality stocks, thereby mitigating a good portion of stock-specific risk. For instance, a Nifty 50 ETF, will allow you to take exposure to a wide variety of industries, without running the risk of a single stock exposure.
• Investing made easy – ETFs enable you to get exposure to a wide variety of asset classes and themes which would not have been possible otherwise. For example, the easiest way to invest in commodities like silver and gold is to buy their ETFs. For that matter, if you want to invest in US stocks, you can either opt for the cumbersome process of opening an account with a foreign broker and pay hefty commissions or simply buy an international ETF in India that holds US stocks. This illustrates the use case of ETFs, as an investment product, in making the life of an investor easy.

At Windmill Capital, we have a dedicated focus towards building an ETF based smallcase, i.e. a portfolio that hold ETFs of different varieties. The reckoning within the team is that ETF based smallcases are a fairly prudent way to build your core portfolio.

So, how do we go about building such smallcases? We follow a set process for the same. To begin with, the smallcase idea is seen from a bird’s eye view to check for what it offers and how different investors can benefit from it. Then, we make a roster of the most liquid ETF instruments in the market, representing the relevant asset classes that we wish to include in our smallcase universe. Next up, we back-test the smallcase to gauge its performance in various market scenarios including extreme bear/bull market to a prolonged sideways market (sideways markets refer to when prices remain almost constant over time). This helps us deploy smart weighting schemes. Essentially, the stress-testing lays out different performance scenarios in front of the team and that aids decision-making as far as weight allocation is concerned. And finally, we take a final call on whether the ETF smallcase is good to launched for investors, keeping the first step closely in mind.

The following page would see detailing of the All Weather Investing smallcase, starting from how it was conceived to investor suitability –

Detailing of the smallcase

All Weather Investing smallcase is a classic one-in-all portfolio, taking exposure to equities, fixed income (read: debt), and gold. It currently holds 2 equity ETFs (Nippon India Nifty 50 Bees ETF, Nippon India Junior Bees ETF), a debt ETF (Nippon India Liquid Bees ETF), and a gold ETF (Nippon India Gold Bees ETF). 

The need of the smallcase arose when we went about asking ourselves whether a portfolio can be built that would be a one-size-fits-all, coupled with adaptibility to all market conditions. Now, these might and should not seem rocket-science to you as they are fundamental nuances around the concept of investing. However, the question still remains: how many have actually been able to achieve it? For any core portfolio to have a strong foundation, it needs to necessarily check 3 conditions – diversification, economic advantage, and adaptability to market cycles. All Weather Investing smallcase does score highly on all these fronts. 

The smallcase has 3-dimensions to it – equity fetches higher returns by taking additional risk, debt acts a stable source of fixed returns along with toning down risk, while gold hedges or protects the portfolio against any extreme event. The portfolio does not have a fixed weight distribution framework and hence is allocated by the team, basis the respective near-term prospects of the markets. For instance, if the team is of the opinion that gold can perform well in the upcoming quarter while equities could lag, a higher allocation would be done towards the former and a lesser one towards the latter.        

As fund managers, we have spoken at lengths about the concept of a core and satellite portfolio. The core portfolio is the fundamental basket that builds foundation, while the satellite basket is the ancillary section that blends the risk-reward and aims to fetch higher returns. All Weather Investing smallcase qualifies as a solid core portfolio as it provides foundation to investing and has the right mix of different asset classes. 

Once every quarter, the research team reviews this smallcase and realigns the weights with the selected asset allocation strategy for the next quarter. The underlying concept that is used for the rebalance is a 2-step process. Firstly, the manager tracks the volatility in the gold and equity markets. Higher the volatility, higher shall be the allocation to fixed income (debt). Post that, the remaining weight is distributed among the other instruments by using the risk-reward model wherein it is ensured that every additional unit of risk taken is maximized for its optimum return.

End Note

As market participants, we have a tendency to reject things that seem to be extremely simplistic in nature. We like to hold on to our illusion of power, where carrying out something complicated feels fruitful. However, at Windmill Capital, the idea within the team is to always keep things straight forward and effective. The above explanation is a testimony of the simplicity with which we have ideated on all our ETF based smallcases and how we manage them. We shall continue to look for opportunities to broaden our offering universe. ETFs are a smart way to take market exposure and combining the right instruments could yield healthy returns. We firmly believe that this simple concept is a powerful tool to create wealth over the long-term.

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