ETF smallcases by Windmill Capital

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 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.

This report is written with the intention to give readers and investors a deep insight into the world of ETF based smallcases and how we as managers go about giving it a coherent shape for you to invest. The following pages would see detailing of every ETF based smallcase, starting from how it was conceived to investor suitability.

All Weather Investing

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.

Equity & Gold

The Equity & Gold smallcase is a hybrid hedge portfolio that houses 2 ETFs of different asset classes. The smallcase has a fixed weight allocation with 70% equity and 30% gold. It currently holds Nippon India Nifty 50 Bees ETF for the equity portion and Nippon India Gold Bees ETF for gold. 

The use-case or the need of the product was a fairly straight-forward one and that is the inverse correlation between equity and gold. Empirical data suggests that gold, being a safe-haven asset class, does well in times of market turmoil – which is also when equity markets are underperforming – and thus they generally are seen to move in opposite directions. This is why gold has proved to be an effective hedge to equity markets. Hedge is essentially a risk management strategy wherein two positions are taken such that they are expected to move in opposite directions, hence neutralizing the effect of any downside extremity. This helps to navigate market concentration. 

The next use-case is from an inflationary perspective. Gold acts as an efficient fighting tool when it comes to inflationary pressures and tends to beat inflation to deliver positive real returns. For instance, if one is exposed to both equity and gold, underperformance in equity markets will get balanced out with gold, as they have historically moved in opposite directions. Hence, we believe that a mix of these two asset classes is a must for sustainable wealth creation. It is an efficient way to achieve capital protection, which each investor needs to be mindful of. 

Even from an individualistic point of view, taking exposure to equity and gold commands merit and is a prudent way of investing into the capital markets. A higher weightage (70%) is maintained given to equity as it helps in growing and generating wealth over the long haul, with a lower blended risk due to the presence of gold (30%), which protects the overall portfolio from large drawdowns.

The Research team reviews this smallcase on a quarterly basis and manages the weight allocation between the instruments. As mentioned previously, since the smallcase is a fixed-weighted one, the rebalancing is focused on the weights every quarter based on the set condition. You would be thinking as to why does the smallcase need rebalancing if it’s a fixed-weighted one, right? That is because the allocation of the portfolio changes as per market price movement. Meaning, if you had put 70 bucks in the equity component at ₹100 and three months down the line, the equity component becomes ₹150 your allocation has got skewed due to price appreciation.  

The smallcase is categorized as Low Volatility. Hence, investors having any degree of risk appetite can consider investing in this smallcase. Equity & Gold smallcase can prove to be a smart route to build your core portfolio. It neutralizes, to a large extent, the risk of market cycles given the combination of the two said instruments. Also, it is prudent to note that this portfolio should be looked at as a tool of long-term wealth creation.

Equity & Debt

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. 

Top 100 Stocks

The unequivocal focus of the Top 100 Stocks smallcase is to invest into the top 100 listed companies on the Indian stock exchange, all large-cap in nature. Sole large-cap presence brings in stability, both from the perspective of volatility, and long-term wealth creation. It currently holds 2 ETFs – Nippon India Nifty 50 Bees ETF and Nippon India Junior Bees ETF.   

The conceptualization of the smallcase was on the back of having an economical product via which one could take market exposure to the biggest companies in India. It is a spin-off from the Top 250 Stocks smallcase, which has a mixture of large-cap and mid-cap stocks. The reason to stick with just the large-caps was to have a specialized portfolio of companies with established underlying business models and a steady return framework combining capital appreciation and modest dividend payouts. 

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 referred to as Minimum Volatility. The objective of the team is to reduce overall portfolio volatility, while at the same time maintaining a healthy rate of return. 

From an investor suitability perspective, this smallcase is categorized as Medium Volatility. Investors who are considering adding an ancillary portfolio to their investment universe should ideally opt for this smallcase. 

Global Opportunities

True to its name, Global Opportunities smallcase invests into both Indian as well as international equities. The smallcase has a proclivity towards international tech companies that have proved to be exceptional wealth creators for investors. It currently holds 3 ETFs – Nippon India Nifty 50 Bees ETF, Nippon India Junior Bees ETF, and Motilal Oswal NASDAQ 100 ETF. 

The core motivation behind this smallcase was the mix of geography. In India, investing in international markets is considered to be an unachievable task,  mainly due to the inefficient cost structure. The general norm is that it is only accessible to a select few with deep pockets. However, that is not the case. Taking exposure to multiple markets (across geographies) drastically increases the odds of better returns. To top it up, the ETF route makes it economically viable for any strata of investors to park money. Previously, we have discussed the concept of diversification and its importance to avoid exigencies. Though the argument could be that it’s essentially the same asset class, geographical development varies to a large extent, especially in the case of a developed and an emerging market, and thus this serves as a good diversification strategy.

Another angle to explore with this smallcase is the presence of both developed and developing markets. As globalization witnesses further paradigm shift, diversification in terms of geography and economic status will turn out to be a significant differentiator. 

The Research team reviews this smallcase on a quarterly basis and manages the weight allocation between the instruments. The smallcase has a fixed allocation model, wherein 50% goes to Indian equities and 50% to International. The smallcase is categorized as Medium Volatility. As mentioned earlier, the smallcase is a cost efficient way to venture into global equities. Global markets, both developed and developing, carry immense value and unlocking it with the help of this smallcase could be a prudent approach. 

Top 250 Stocks

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. This report 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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