Making A Portfolio Of Exchange Traded Funds

Passive investing is catching the eyes of many investors due to the inability of the actively managed funds to outperform the benchmark. This is specifically true for most of the actively managed large-cap funds. ETFs are one of the ways in which you can passively invest in stock markets. The article provides further details of how to create such a portfolio

The investing trend, like everything else, keeps changing. Globally, especially in developed markets like the US, we have been witnessing a marked shift in the investors’ preference towards passive investing. The green shoots of a similar trend are visible among Indian investors also. In the last one year from January 2021 to January 2022, there was a 60 per cent rise in the assets under management (AUM) of passive investments. However, it is still at a nascent stage when compared to the US and other developed markets. For the US market, passively managed funds (ETF and index funds) were almost 40 per cent of the GDP at the end of 2020 while for India these were around 3 per cent.

The AUM of passively managed funds is consistently rising high while the net inflows seem to be quite choppy. Having said that, the net inflows post December 2020 have improved quite a bit with average net inflows in the last three years being Rs 6,182 crore. The AUM of exchange traded funds (ETF) including gold ETFs in the last one year has surged almost 50 per cent while in the case of index funds it is a whopping 225 per cent rise in the same period. It has been seen that inflows into the index fund are mainly driven by retail investors. Hence, this rise in index funds shows the interest of retail investors in index funds. Below is the list of top 15 passively managed investments that did quite well over the longer period.

Shifting Towards Passive Investment

There are three major reasons due to which investors are preferring funds with passive investment strategies.

1. Active Funds Failing to Outperform the Benchmark: A majority of the actively managed funds over the short term as well as the long term, specifically the large-caps, have underperformed their benchmark indices. According to a study carried out by the S&P Indices versus Active Funds (SPIVA), over the one-year period ending June 2021, the S&P BSE 100 was up 55.96 per cent with 86.21 per cent of the large-cap funds underperforming the benchmark. Over H1 2021, 53.13 per cent of the funds underperformed the S&P BSE 100. Over longer horizons, the majority of the actively managed large-cap equity funds in India underperformed the benchmark, with 65.93 per cent of large-cap funds underperforming over the 10-year period ending June 2021. Over the same period, Indian large-cap funds witnessed a low survivorship rate of 70.37 per cent.

2. Expense: The average expense ratio of actively managed large-cap funds in India hovers from 1.5 per cent to 2.5 per cent, whereas the same for passive funds is in the range of 0.05 per cent to 0.3 per cent which brings in a huge cost advantage, especially looking at it from a long-term perspective.

3. Support from Regulators and Government: There are multiple initiatives taken by the Securities and Exchange Board of India (SEBI) and the government such as introduction of direct plans in mutual funds, incentives for penetration of mutual funds beyond the top 30 cities, re-categorisation of mutual funds and the introduction of Total Return Index (TRI) as a benchmark aiding growth in mutual funds and passive assets. Other initiatives such as disinvestment via ETFs, allowing Employee Pension Fund Organisation (EPFO) to invest in ETFs and the recent introduction of silver ETFs all support the growth of passive assets.

The Reluctance Factor

Despite being such a path-breaking product, there is some reluctance from retail investors to invest in ETFs. This might be due to its structure wherein you need to check its liquidity before investing and the mandatory demat account to invest in ETFs. Moreover, you can invest only during market hours as you do for stocks. When you invest in index funds you do not need a demat account and you can invest anytime. NAV is applicable as per cut-off rules. That said, the major advantage of ETFs is timely entry and exit and it’s not just the underlying that decides the price of ETF but also the demand.

One more big advantage in favour of an ETF is that the expense ratio in an index ETF is much lower than an index fund. In India, generally an index fund has an expense ratio of around 1 per cent while index ETFs have an expense ratio of about 0.3 per cent. Therefore, we believe building a portfolio of ETFs makes more sense. So, in this article we would be helping you build your ETF portfolio. You just need to assess your risk profile and select the ETF portfolio accordingly.

Conservative Investor

For conservative investors we have kept the equity allocation low and debt allocation high. This portfolio will not just help you to ride volatility but get better real rate of returns than investing in bank fixed deposits (FD).

Although the indicative performance of the conservative portfolio shows that it underperforms Nifty 50 TRI, it provides better downside protection compared to Nifty 50 TRI. The standard deviation of conservative portfolio stands at 8 per cent, which is lower as compared to Nifty 50 TRI that stands at 17 per cent. However, the compounded annual growth rate (CAGR) of a conservative portfolio is lower at 11.39 per cent than 13.96 per cent for Nifty 50 TRI. The conservative portfolio scores over Nifty 50 TRI in terms of risk-adjusted returns as measured by Sharpe ratio. The Sharpe ratio of conservative portfolio stood at 0.68 while that of Nifty 50 TRI was 0.47.

Moderate Investor

For moderate investors we have inched the equity allocation by keeping the debt allocation reasonable. This portfolio is meant for those whose risk profile sits in the middle of conservative and aggressive risk profiles.

The indicative performance of the moderate portfolio shows that most of the times the returns are in line with that of Nifty 50 TRI. In fact, at times it has even outperformed the Nifty 50 TRI by taking lesser risk compared to Nifty 50 TRI. The standard deviation of moderate portfolio stands at 11 per cent, which is lower as compared Nifty 50 TRI that stands at 17 per cent. However, the compounded annual growth rate (CAGR) of moderate portfolio is similar to that of Nifty 50 TRI. The CAGR of moderate portfolio and Nifty 50 TRI stand at 13.81 per cent and 13.96 per cent, respectively. The moderate portfolio scores over Nifty 50 TRI in terms of risk-adjusted returns as its Sharpe ratio stands at 0.69, while that of Nifty 50 TRI is 0.47.

Aggressive Investor

As aggressive investors have higher risk tolerance, we have further inched the equity allocation compared to conservative and moderate portfolios by keeping the debt allocation minimal. This is a risky portfolio and is subject to higher volatility compared with conservative and moderate portfolios.

The indicative performance of the aggressive portfolio clearly shows that the aggressive portfolio has consistently outperformed Nifty 50 TRI. In fact, this performance by the aggressive portfolio is by taking lower risk compared to Nifty 50 TRI. In terms of risk as measured by standard deviation, an aggressive portfolio’s standard deviation is 14 per cent, while that of Nifty 50 TRI is 17 per cent. Also, the compounded annual growth rate (CAGR) of aggressive portfolio is higher compared to Nifty 50 TRI. The CAGR of aggressive portfolio and Nifty 50 TRI is 15.65 per cent and 13.96 per cent, respectively. Even in terms of risk-adjusted returns as measured by Sharpe ratio, aggressive portfolio beats Nifty 50 TRI. The Sharpe ratio of aggressive portfolio and Nifty 50 TRI is 0.7 and 0.47, respectively.

Conclusion

Passive investing is catching the eyes of many investors due to the inability of the actively managed funds to outperform the benchmark. This is specifically true for most of the actively managed large-cap funds. ETFs are one of the ways in which you can passively invest in stock markets. However, many investors find it difficult to create a winning portfolio of ETFs due to the way it is structured. Thus, in this article we have tried to help you with the same by suggesting a model portfolio of ETFs for conservative, moderate and aggressive risk-takers.

Our suggested portfolio has succeeded in containing the downside risk when compared to Nifty 50 TRI. Moreover, even the Sharpe ratio, which was used to measure the risk-adjusted returns, was better for the recommended portfolios. As such, ETFs are one of the most efficient ways of investing that allows you to keep your costs low and thereby get better real rate of returns to achieve your financial goals. But before you choose among the recommended portfolios, it is prudent to assess your risk profile. Also, you should re-balance your portfolio at least annually to get better results.

"By periodically investing in an index, the know-nothing investors can actually outperform most investment professionals." - Warren Buffett