Building A Portfolio With Exchange-Traded Funds

Diversification is the key to good investments. In this space, exchange-traded funds (ETFs) are investment funds that hold a diversified portfolio of assets, such as stocks, bonds or commodities. By investing in an ETF, you instantly gain exposure to a broad range of securities, which can significantly reduce risk. The article elaborates on this topic with a case-study.

Let us consider the story of a naive investor, Ravi Gupta, who was just beginning his journey into the world of investments. Ravi was filled with excitement and ambition as he watched the stock market flourish, and he couldn’t resist the allure of making his fortune through investing. Ravi was excited to get started, especially considering how the market had been performing well lately. He envisioned building his wealth through investments. As Ravi took his first steps in the world of investing, he purchased stocks of a few Indian companies. 

This included some of the prominent banks that had performed consistently over some years such as HDFC Bank and Kotak Bank, which seemed promising. However, he soon realised that while the overall market was doing well, his investments were not performing as per his expectation. Confused and disheartened, he knew he needed to learn more about investing. Ravi began to immerse himself in research, and he stumbled upon the concept of diversification. He discovered that the key to a successful investment was spreading investments across different stocks to manage risk. Diversification, he realised, was the first step in constructing a resilient portfolio. 

As he delved deeper into the topic, he came across the wisdom of Harry Markowitz, who famously said, “Diversification is the only free lunch in investing.” This quote left a lasting impression on Ravi and became his guiding principle. This new-found knowledge motivated Ravi who decided to revamp his investment strategy. He started holding more stocks from different sectors, industries and market segments, both within India and globally. His portfolio became diversified, and he believed he had found the key to successful investing. However, as the market experienced some turbulent times post the Russia-Ukraine conflict, Ravi found himself disheartened once more. 

He realised that even with a well-diversified portfolio, he couldn’t guarantee good returns in a volatile market. Determined to not give up, Ravi decided to dig even deeper into the concept of diversification. He understood that diversification should extend beyond just equities. He learned that true diversification meant investing in various asset classes, including commodities and fixed income securities. His next significant concern revolved around the practicality of diversifying across a multitude of assets, given the extensive research and ongoing monitoring required for individual investments. As a solution, he opted to navigate the ETF route. 

ETFs: Diversification Made Easy

Exchange-traded funds (ETFs) are investment funds that hold a diversified portfolio of assets, such as stocks, bonds or commodities. By investing in an ETF, you instantly gain exposure to a broad range of securities, which can significantly reduce risk. For example, an ETF tracking an index like the Nifty 50 or the Sensex provides you with exposure to a diverse set of Indian equities. ETFs are typically passively managed, aiming to replicate the performance of a specific index or benchmark. 

This means they are low-cost and designed to offer a simple way to gain diversified exposure. ETFs trade on stock exchanges just like individual stocks. This provides you with the flexibility to buy and sell throughout the trading day at market prices. Additionally, ETF holdings are disclosed daily, offering transparency about the fund’s composition. ETFs are known for their low expense ratios, making them a cost-effective way to invest. Since they are passively managed, there are fewer management fees involved. 

ETFs cover a wide range of asset classes, including equities, bonds, commodities, and even international markets. You can choose ETFs that align with your specific investment goals. ETFs and even mutual funds are excellent tools for diversification because they provide a hassle-free way to invest in a wide range of assets, managed by professionals, at a reasonable cost. By including these investment vehicles in your portfolio, you can achieve the diversification necessary to weather the ups and downs of the Indian market while aligning with your risk profile and investment objectives. 

ETF Portfolio Analysis

To understand how these multi-asset ETFs perform when we weave them into a portfolio, we took three ETFs representing three different asset classes i.e. equity, fixed income and commodity. We further analysed this portfolio. For equity we took Nippon India ETF Nifty 50 BeES, for fixed income we took BHARAT Bond ETF April 2030 and for commodity we took Nippon India ETF Gold BeES. Our period of study was between January 2020 and October 2023. 

Over this time period of about 3 years, we tried to gauge the performance of all three asset classes along with a portfolio made out of them. We carried out an annual rebalancing of this portfolio. The reason we selected these three asset classes was because of their low correlation. Low correlation of assets is important for making a portfolio because it helps to reduce risk. When assets are correlated, they tend to move in the same direction. This means that if one asset in a portfolio loses value, the other assets are likely to lose value as well. 

However, when the assets are uncorrelated, they tend to move independently of each other. This means that if one asset in a portfolio loses value, the other assets may not lose value, or they may even lose less value. By diversifying a portfolio with assets that have low correlation, investors can reduce their overall risk. This is because even if one asset loses value, the other assets are likely to perform better. This can help to smooth out the returns of the portfolio and reduce the volatility 

The Correlation Factor 

Over the period December 30, 2019 to October 23, 2023, all the three individual asset classes showcased positive total returns, with Nifty leading at 63.65 per cent, followed by gold at 50.26 per cent and bonds at 29.56 per cent. The portfolio constructed from these assets in the ratio of 60:30:10 for equity, debt and gold respectively delivered a respectable total return of 55.38 per cent, showcasing the benefits of diversification. When examining risk-adjusted performance, it’s noteworthy that bonds displayed the highest daily Sharpe and daily Sortino ratios, highlighting its relatively superior risk-adjusted return compared to Gold and Nifty. 

The CAGR (compound annual growth rate) for the three individual asset classes and the portfolio was respectable, with Nifty leading at 13.79 per cent. Nonetheless, such performance comes out with a larger drawdown. Nifty experienced the largest maximum drawdown of -36.34 per cent, reflecting its comparatively higher volatility. However, its Calmar ratio, measuring risk-adjusted return to maximum drawdown, was lower than bonds, indicating that bonds provided a better risk-return trade-off. 

The average drawdown and the number of days spent in a drawdown for the portfolio were more favourable than Nifty. Finally, when looking at monthly performance, Nifty consistently showed higher average up months, while bonds displayed the lowest average down months, underlining its relative stability. In summary, this analysis underscores the potential benefits of a well-diversified portfolio, with bonds contributing to risk reduction and equity and gold giving boost to the performance. 

Performance Analytics ETF

The above example is only for illustration purpose. Depending upon one’s risk profile and goals, one can alter the allotted weight and can add other sub-asset classes to suit their risk return profile. With different combination and weightage, individual investors can create an appropriate investment strategy tailored specifically toward meeting their long-term financial goals while managing risks effectively along the way. 

Portfolio Diversification and Financial Security 

With this new insight in mind, Ravi diversified further. He began to allocate his investments across different asset classes, including stocks, bonds, and commodities like gold. This broader mix of assets provided him with a more stable and less volatile investment journey, regardless of market fluctuations. 

Ravi recognised the importance of aligning his asset allocation with his risk profile. As a conservative investor, he favoured adding more fixed-income assets, such as bonds to his portfolio. He understood that investors with higher risk tolerance could allocate a larger portion of their investments to equities. 

As time passed, Ravi’s investment journey continued, and he faced both bull and bear markets in the Indian context. However, with his diversified portfolio, extending beyond just stocks, and a careful consideration of asset allocation, he was better equipped to navigate the ups and downs of the stock markets. He had come a long way from his naive beginnings, now a seasoned investor who understood that diversification was indeed the key to a more secure and prosperous financial future. What’s more he understood the importance of using ETF as an investment vehicle to execute his investments.