Using ETFs for quick gains

The Nifty 50 Index climbed about 25 per cent in nine months. Did you participate in this uptrend? You are not atypical if you stayed away from the market for most of this period. Many like you did not ride the uptrend, fearing a reversal in stock prices sooner than later.

But you do not have to bet on individual stocks to participate in an uptrend. One way to do so is to create a portfolio of Exchange Traded Funds (ETFs). Here’s taking a look at how you should create such a portfolio.

A satellite portfolio is set up to capture short-term fluctuations in the market. Therefore, the assets in this portfolio are frequently traded, with a holding period of not more than one year. Your satellite portfolio should typically hold volatile assets such as equity and gold.

There are two ways you can capture short-term price uptrend. You can buy individual securities or you can bet on an index. Taking a bet on individual securities is risky because the stock you buy can decline in value.

Betting on, say, the Nifty Index is less risky. The advantage is that the Nifty Index could move up even if, say, five securities forming part of the Index decline! Besides, taking a directional view on an index is easier than taking a view on an individual stock. You should, therefore, build a satellite portfolio with ETFs. We call such a portfolio ETF Managed Satellite Portfolio.

Because ETFs are passive products (with a few exceptions in the US), building a portfolio of ETFs would require you to buy equity ETFs on different benchmark indices.

You should look for four kinds of indices. The first is the style index, which is based on size. Large-cap index such as Nifty 50 Index, for instance. The second kind is a sector index such as NSE Bank Index. The third kind is a thematic index that combines several sectors based on a common investment theme. Nifty Infrastructure Index, for instance. The fourth kind is the strategy index such as the Nifty Dividend Opportunities 50 Index. Investment vehicles on such non-market-cap-based indices are called Smart Beta products.

Your ETF Managed Satellite Portfolio could contain a large-cap ETF, a mid-cap ETF, a sector ETF, a style ETF and thematic ETFs. Besides, you should consider a Gold ETF. Your satellite portfolio should not contain bond ETFs, as they expose you to downside risk with limited upside potential; for bond ETFs trade based on NAV. The next question is: When is the right time to buy ETFs?

You should time the purchase of the ETFs in your satellite portfolio, as the objective is to capture short-term price fluctuations. You should, therefore, buy and sell ETFs based on technical analysis. So, liquidity is an important factor for building the ETF Managed Satellite Portfolio. Based on the current trading data, liquidity appears to be decent in Nifty ETFs, Bank ETFs and CPSE ETF.

Such frequent buying and selling is not possible with index mutual funds, as asset management firms levy a penalty for redemption of units held for less than one year.

You could also invest in global indices in Indian currency. ETFs are currently available on the Hang Seng Index and on the Nasdaq 100 Index. You should buy these ETFs only if you want to bet that the underlying indices will rise, and not to diversify your investments.

Remember, your objective is market timing with appropriate risk management. This means you should have a concentrated, not a diversified, portfolio.

Finally, do not diversify your investments within the same ETF universe, as they are passive products. For instance, you should not invest in 2-3 Nifty ETFs. All Nifty ETFs will generate similar returns; the marginal difference will be due to variation in fund fees and expenses.

The author is the founder of Navera Consulting. Feedback may be send to portfolioideas@thehindu.co.in