Musings with Analyst – August 2022

When you work in capital markets, one of the most asked questions is – ‘What is Portfolio Construction?’ Don’t get me wrong, the most asked one still is – ‘Which stock to buy?’

Anyhow, on a serious note what is portfolio construction? Sure, it sounds intellectual and overwhelming to say the least, but at the core of it, perhaps one of the most intuitive concepts. Think of it as constructing a building. Before anything else, the constructor has to gather all the relevant factors that will contribute to the building construction. Then, the first step is to build a solid foundation followed by subsequent storeys. Portfolio construction is likewise.

Essentially, portfolio construction involves gathering a bouquet of factors and amalgamating it as per the investment strategy, in order to arrive at the final set of stocks. Now, let’s break down the aforementioned statement and understand the process.

You see, for someone to build a portfolio, the base of it is the underlying strategy/theme. For instance, if I wish to create a portfolio around smart beta or asset allocation, my stocks universe between the two will be starkly different. Same goes for themes as well. A rural based theme and a specialty chemicals theme will have distinct stocks universes. Even for the same theme, strategies can differ on the basis of a lot of factors, for instance companies’ market cap. So, a momentum portfolio can be built only on large-cap stocks, or entirely on small-cap ones. 

The point being that a well-defined strategy/theme is the stepping stone of portfolio construction. This takes us to the next most important aspect – stock universe selection. It is essentially the process of picking your set of final stocks from the universe, on the basis of a combination of factors/criteria. There are various permutations and combinations that go behind distilling down the final set. 

To give you an example, let’s say I am designing a strategy and I take into consideration the top 500 companies by market cap. As per SEBI classification, the top 100 companies will be large-cap stocks, 101-250 will be mid-cap stocks, and the last 250 will be small-cap stocks. Now, if my strategy is of a particular type wherein it only wants to choose large cap stocks, my universe shrinks from 500 to 100. Basically, each strategy criterion shrinks the stocks universe further and further to get to the final list.   

For that matter, renowned index houses also have well defined universes underlying their respective indices. For instance, Russell 1000 has a universe of the largest 1000 US companies or MSCI factor indices which are based on volatility, momentum, and others.

Even for a manager who is managing a global portfolio further has to deal with universes ranging from stocks of multiple countries. Say for eg, a universe of stocks from India, China wherein a manager creates a portfolio of stocks exhibiting lowest monthly volatility. He may then have to make his universe combining 2 countries and then further select the large-cap segment only to finally filter low vol stocks.

At Windmill Capital, we maintain north of 50 smallcases spread across a variety of investment strategies. Listed below are all the different categories of smallcases and their corresponding examples.

• Asset Allocation – All Weather Investing, Horizon smallcases
• Thematics – Brand Value, Specialty Chemicals
• Models – CANSLIM-esque, Dividend Aristocrats
• Trackers – IT, Pharma Tracker 
• Smart Beta – Low Risk, Quality Smallcap

All these smallcases have predefined stock universes on which the final set of portfolio is screened and built. To give you some perspective, Quality Smallcap – Smart Beta only considers smallcap companies while Dividend – Smart Beta considers large cap ones. Similarly, tracker smallcase’s universe comprises relevant sectors within the top 700 stocks in India.

The idea behind giving you a tour on the intricacies of the stocks universe is to convey its importance in constructing a portfolio as it being the stepping stone. All professional investment managers first align their universes based on their theme/strategy and subsequently drill down to the final set of stocks based on certain rules. At Windmill Capital also, since we deal with a variety of smallcase themes/strategies, setting up a stock universe is an essential part of our workflow.