Equity & Debt

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. 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 backtest 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 Equity & Gold smallcase, starting from how it was conceived to investor suitability –

Detailing of the smallcase

The Equity & Debt portfolio is a classic 2-in-1 low risk portfolio with a healthy coverage from both the universes. The smallcase has a fixed weight allocation of 60% towards equity and 40% towards debt. It currently holds 3 ETFs – Nippon India Nifty 50 Bees ETF, Nippon India Junior Bees ETF, and Edelweiss Bharat Bond ETF2030; subject to change. 

So how did we come about finding the need for this portfolio? It came from a simple yet important belief that our team shared within themselves and that was to not put all your eggs in one basket. And this is extremely relevant from an investing context. For any sort of investor, he/she needs to park money in different asset classes so that when things go south with Asset A, Asset B and C act as cushions and help maintain balance in the overall portfolio. To add a finer touch to it, we decided to play on this theme with the help of appropriate ETFs. The equity portion of the smallcase has a dynamic nature, just like equity markets are expected to behave, usually drawing in higher returns. On the other hand, the debt portion acts as a steady bedrock fetching stable returns irrespective of market conditions.

As far the quarterly review is concerned, the primary focus of the smallcase manager is the asset class attribution. The manager checks to see the current weight distribution and adjusts the same, if the need arises. For instance, since the weight allocation is fixed between equity and debt (60% and 40%), if the smallcase stands at a weight distribution of 65% equity and 35% debt, then the manager shall reduce equity by 5% and increase debt by 5% to bring it back to the initial framework. An important thing to bear in mind is that the weight distribution gets distorted due to market price movements. 

The smallcase is categorized as Medium Volatility. A product that could act as a supplement to an investor’s core portfolio. The component of risk is fairly muted and hence works best for participants chasing stable returns over a long period of time. There is merit to add here that ETF based smallcases do face a possibility of running into a prolonged bear market due to its constituents composition and hence investors with a short-term view must be cautious while opting for such products. 

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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