Top 250 Stocks

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 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 the Top 250 Stocks smallcase, starting from how it was conceived to investor suitability –

Detailing of the smallcase

As the name suggests, it takes exposure to the top 250 companies by market capitalization via the route of ETFs. The smallcase is a pure diversification play, currently holding 3 Exchange Traded Funds (ETFs) – Nippon India Nifty 50 Bees ETF, Nippon India Junior Bees ETF, and Nippon India Nifty Midcap 150 ETF; subject to change. The first two ETFs hold large-cap names (basically the top 100 stocks by market cap), while the third one houses mid-cap companies (next 150 by market cap).

As far as the conceptualization of the smallcase is concerned, the core motivation to give life to this smallcase was to build a cost-efficient way of taking exposure to the top companies listed on the exchanges. You see when you invest in the stock markets, you are exposed to two types of risks- systemic risk and unsystematic risk. Systemic risk is a type of risk that runs on a broad ecosystem level. In other words, you, as an investor, cannot mitigate systemic risk and would invariably be exposed to it, as a by-product of being a market participant – for instance the Covid-19 market crash. Unsystematic risk, on the other hand, is that type of risk that is specific to an asset class or a company or a sector, for instance the Yes Bank fiasco leading to share price erosion. Naturally, an investor is capable enough to optimize for this risk type. The concerned smallcase, by nature of the market, strives to mitigate unsystematic risk. Since it takes exposure to the top 250 stocks listed on the exchanges, it neutralizes the unsystematic risk to a large extent. Our focus was to open options for all sorts of investors who would want to enter the equity markets, albeit with a modest capital. The need for such a product stays intact, given the benign penetration of our markets. 

We believe the mix of large-cap and mid-cap is a prudent way to take exposure in the equity markets. While the former (large cap) companies have established credibility as well as business moat to command market share, the latter ones (mid-caps) are at a crucial growth trajectory to become a force of reckoning. The most distinct characteristic of large-cap companies is their successful business model. They have spent a good amount of time in the markets and have convinced market participants with regards to their operating framework. Secondly, most of these companies are known for dishing out a part of their profits to shareholders in the form of cash dividends. That proves to be an alternate source of inflow for the stakeholders. Lastly, their stock prices are fairly less volatile as compared to that of the smaller players. This ensures capital protection. Mid-cap corporations are usually smaller in size, with higher propensity to grow at a breakneck speed. They necessarily don’t command fat market share, however are on the course of becoming an established player.

The crucial role on our part is to optimize for the weights. The focal point of the weight distribution, for Top 250 Stocks smallcase, is risk-adjusted return. Before understanding risk-adjusted return, it is imperative to understand the smallcase’s rationale. The objective of this smallcase is to achieve maximum returns by undertaking the lowest amount of risk. To put forth further context, we define risk as the volatility of a portfolio. Risk adjusted return is a concept which measures the return attained with respect to the risk undertaken. In other words, if two portfolios have the same returns, the one with a lower risk element would have higher risk-adjusted return. This weight allocation is reviewed periodically, in order to tackle any divergence during the course of the investment period.

Once every quarter, the research team reviews this smallcase and realign the weights with the selected asset allocation strategy for the next quarter. From an investor suitability perspective, this smallcase is categorized as High Volatility. Therefore, this basket should act as an ancillary to an investor’s core portfolio. Investors with a medium to high risk profile can consider this to be an addition to their equity portfolio. 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 should 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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