Investing in ETFs

So I put some money in an ETF today. This isn’t the first time I invested in one. A long time back, before my then employer had bought and essentially killed Benchmark, I had invested in a couple of their ETFs – the Nifty ETF to get invest in the broad Indian market, and GoldBees to hedge against increase in the price of gold as I was planning my wedding.

I had some Rupees lying around in my bank account for a long time, and given that the Indian markets have tanked, I thought this is a good time to get invested. In fact, this isn’t the first time in recent times I’m having such a thought – about a month back I had put in more money into the Indian markets, but had then chosen a low cost index tracking mutual fund (and I’m not tracking how my investment is doing).

Anyway, today I decided to invest in ETFs since the transaction costs (in terms of both trading, and annual expenses) are much lower. A quick chat with a friend currently trading the Indian markets revealed that the SBI Nifty ETF is the best option to go with, and I was left with the small matter of just making the investment.

I’m generally happy with ICICI Direct as my broker, since in general the interface and app are pretty nice. Last month, the purchase of the mutual fund through the same app had been pretty simple. And I imagined buying the ETF will be easy as well. It wasn’t. And if I, as a professional investor with considerable capital markets experience, find it hard to invest in ETFs, I can only imagine how hard it might be for mango people to invest in them.

So the points of pain, in order, that prevent people from investing in ETFs:

  1. Knowing that indexing exists. Most people seem to think that the only ways to invest are by researching the stocks themselves, or by paying an asset manager fairly hefty fees.
  2. Once you know you can index, the fact that you can do it through an ETF. ETFs are again not well known, and not really marketed broadly since their fees are low (with Benchmark’s demise, we don’t really have ETF-first fund houses in India, like we have Vanguard in the US).
    1. Related, even some of the more popular robo advisory funds in India largely use mutual funds, rather than ETFs.
  3. Once you know you can index, and do so through an ETF, the next task is to find out which ETF you should invest in. Literature exists, but is not easy to find. My friend sent me this page, and asked me to select the fund with highest market size. Knowing that I want to invest in the broad market, and in large caps, the choice of SBI Nifty ETF was easy for me.
    1. But it’s not so intuitive for a less sophisticated investor. For example, correlating asset size with liquidity isn’t exactly intuitive.
    2. Different ETFs track different indices, and knowing which one to invest in is again not a trivial task.
  4. Having selected an ETF to invest in, you go to your broker’s site or app (I used the app). And you need to know that ETFs are clubbed with equities, and not with mutual funds (not an intuitive classification for most people)
  5. So I go to ICICI Direct’s Equities page, allocate funds to it (from my bank account, also with ICICI), and hit “buy”. There’s a text box where I need to enter what I’m looking for, and then there’s a dropdown that pops up.

    I type “SBI”, and the first thing it shows is the SBI Bank Nifty tracker. This is followed by lots of bonds. I don’t know if it’s clever nudging on ICICI’s part to get you to invest in the Bank Nifty, since that has a significant exposure to ICICI, or if it’s something as mundane as alphabetical sorting. The latter is more likely.

  6. Scrolling down the list past all the bonds, it’s not easy to know which is the SBI Nifty ETF. Because there’s a “SBI Nifty Next 50 ETF” (smaller caps, so more volatile, not something I want), and a few others with confusing names.
  7. Then you need to enter the number of units you need to purchase. This is unlike in mutual funds where you just enter the amount you want to invest. Here I had to pull up a calculator to know exactly how many units I had to buy.
  8. I hit “market order”, and then on the next screen I got a warning that since this wasn’t a particularly liquid instrument I was only allowed to post limit orders. So I had to guess what was a reasonable spread I was willing to pay, and put that. Thankfully the ETF was fairly liquid, and I got execution close to mid.

Honestly, I felt rather daunted at the end of the exercise, and I’m what most people would classify as a sophisticated investor. So there is no wonder that more people aren’t investing in ETFs.

The advantage of ETFs is extremely low fees (the fund I purchased today charges 7 basis points a year), and one downside of it is that it doesn’t allow for more marketing budget.

I’m beginning to think that the way to “solve” this market is by having a bundled ETF and robo advisory offering. Perhaps more on that later.

 

 

Weighting indices

One of the biggest recent developments in finance has been the rise of index investing. The basic idea of indexing is that rather than trying to beat the market, a retail investor should simply invest in a “market index”, and net of fees they are likely to perform better than they would if they were to use an active manager.

Indexing has become so popular over the years that researchers at Sanford Bernstein, an asset management firm, have likened it to being “worse than Marxism“. People have written dystopian fiction about “the last active manager”. And so on.

And as Matt Levine keeps writing in his excellent newsletter, the rise of indexing means that the balance of power in the financial markets is shifting from asset managers to people who build indices. The context here is that because now a lot of people simply invest “in the index”, determining which stock gets to be part of an index can determine people’s appetite for the stock, and thus its performance.

So, for example, you have indexers who want to leave stocks without voting rights (such as those of SNAP) out of indices. Some other indexers want to leave out extra-large companies (such as a hypothetically public Saudi Aramco) out of the index. And then there are people who believe that the way conventional indices are built is incorrect, and instead argue in favour of an “equally weighted index”.

While one an theoretically just put together a bunch of stocks and call it an “index” and sell it to investors making them believe that they’re “investing in the index” (since that is now a thing), the thing is that not every index is an index.

Last week, while trying to understand what the deal about “smart beta” (a word people in the industry throw around a fair bit, but something that not too many people are clear of what it means) is, I stumbled upon this excellent paper by MSCI on smart beta and factor investing.

About a decade ago, the Nifty (India’s flagship index) changed the way it was computed. Earlier, stocks in the Nifty were weighted based on their overall market capitalisation. From 2009 onwards, the weights of the stocks in the Nifty are proportional to their “free float market capitalisation” (that is, the stock price multiplied by number of shares held by the “public”, i.e. non promoters).

Back then I hadn’t understood the significance of the change – apart from making the necessary changes in the algorithm I was running at a hedge fund to take into account the new weights that is. Reading the MSCI paper made me realise the sanctity of weighting by free float market capitalisation in building an index.

The basic idea of indexing is that you don’t make any investment decisions, and instead simply “follow the herd”. Essentially you allocate your capital across stocks in exactly the same proportion as the rest of the market. In other words, the index needs to track stocks in the same proportion that the broad market owns it.

And the free float market capitalisation, which is basically the total value of the stock held by “public” (or non-promoters), represents the allocation of capital by the total market in favour of the particular stock. And by weighting stocks in the ratio of their free float market capitalisation, we are essentially mimicking the way the broad market has allocated capital across different companies.

Thus, only a broad market index that is weighted by free flow market capitalisation counts as “indexing” as far as passive investing is concerned. Investing in stocks in any other combination or ratio means the investor is expressing her views or preferences on the relative performance of stocks that are different from the market’s preferences.

So if you invest in a sectoral index, you are not “indexing”. If you invest in an index that is weighted differently than by free float market cap (such as the Dow Jones Industrial Average), you are not indexing.

One final point – you might wonder why indices have a finite number of stocks (such as the S&P 500 or Nifty 50) if true indexing means reflecting the market’s capital allocation across all stocks, not just a few large ones.

The reason why we cut off after a point is that beyond that, the weightage of stocks becomes so low that in order to perfectly track the index, the investment required is significant. And so, for a retail investor seeking to index, following the “entire market” might mean a significant “tracking error”. In other words, the 50 or 500 stocks that make up the index are a good representation of the market at large, and tracking these indices, as long as they are free float market capitalisation weighted, is the same as investing without having a view.

Why VCs continue to fund me-too startups

In a previous post, I had written about how a large number of startups in India are “me-too” companies, and that a sector, once it becomes hot, gets overcrowded. I had also expressed incredulity at the fact that Venture Capitalists continue to fund such “me-too” startups despite knowing that they are copies of companies that exist.

Thinking about it, however, there is one reason that makes the decisions by VCs to fund me-too startups worthwhile – mergers and acquisitions. And this hypothesis is based on M&A activity in the “hyperlocal delivery” (one of those “hot” buzzphrases) space.

Nowadays, due to activity in the sector, the hyperlocal delivery sector has become the equivalent of Pets.com from the turn of the millennium. At a conversation a month ago, for example, a bunch of us weren’t able to fathom how something like Swiggy is valued at what it is, given its decidedly low-tech business of taking packed food from restaurants and delivering it to customers. A couple of months before that, TinyOwl, which is in a very similar business, had raised similar money.

But then two events in the recent (and maybe not-so-recent) past have indicated why VCs continue to invest (and heavily ) in such sectors. Firstly, in February, Foodpanda acquired the Indian operations of Justeat. Both companies are in the business of delivering packed foods from restaurants to people’s homes. And last week, grocery retailer BigBasket acquired Delyver, yet another company in the business of transporting packed food from restaurants to homes.

There is this Panchatantra story about a Jackal and a dead elephant. Basically a jackal comes across a dead elephant, and wants to eat it. But for this, he has to fight off other competitors, and also get the elephant’s skin torn in the process. The story involves how he uses different strategies to outwit different animals. Here is a youtube video, not very well made, of this story:

This is the cover of the  Amar Chitra Katha edition where I first came across this story.

And this link has a good summary of the story, all you need to know. Exactly like how it’s in the Amar Chitra Katha story.

The moral I derive from this story in this context is that there are different ways to deal with opponents/competitors. Some opponents you just fight off and finish. Others you learn to coexist with. Yet other you simply “swallow” or acquire. Each of them has its own set of payoffs.

Based on the deals described above, what we notice in the “transport-of-packed-food-from-restaurant-to-homes” business is that companies are preferring to swallow each other (and coexisting with some others) rather than fighting. And when one company acquires another, investors in the target company get a “soft landing”, and don’t lose all of their investment (though it is well possible that the acquisition happens at a valuation lower than that when the investors invested, but ratchets might take care of that).

Apart from investors not losing too much, the advantage of acquisitions is that existing infrastructure of an erstwhile competitor can be leveraged. And when companies are in growth mode and profit and cash are not as important as growth, an acquisition works really well in generating significant inorganic growth. It is a win-win for multiple reasons.

The fact that mergers are the preferred way of getting rid of competition in the startup world puts a cap on the losses an investor might have to bear on an investment (and there are ratchets in any case). And since the downside is now limited, the risk of investing in a me-too startup is significantly lower. In other words, investors invest in a me-too startup since they believe that in the near-worst case it will get acquired rather than shut down. And as a further consequence, there is more incentive for entrepreneurs to set up me-too startups (assuming they can get funded) rather than venturing into virgin territory.

Investing

I made some money in the markets last week. I bought the Nifty (September futures) at around 5190 on the 28th of August and cashed out at 5660 on the 6th of September. A fair trade I think, considering that so far in my life I’ve been a fairly poor investor (despite having worked as a quant at an investment bank and a hedge fund). This trade, however, raised more questions than answers.

Firstly, the markets have gone up significantly after I sold out. I exited at 5660. The Nifty closed today at well over 5900. Last couple of days I’ve been wondering if I panicked and cashed out too early. I must admit that when I entered I had a target price of 6000. However, given the rather choppy nature of the Indian markets, I decided that the 10% appreciation in 10 days was enough and cashed out. To that extent, I didn’t stay honest to the strategy I entered the trade in.

However, the reason I decided to cash out when I did was that I thought the market was going to top out and a steep fall was imminent. From that perspective, it made sense to cash out when I did. Yes, I might have made more money had I hung on for another two trading days, but there was no guarantee that the markets would continue to rise. In that sense I was happy pulling out.

More importantly when I cashed out, I realized that I’m still an amateur at investing. When you are a professional investor, you look at investment vehicles in terms of opportunity cost. If you wanted to pull out of the Nifty, you would do so only if you could put your money in another investment which would give you superior returns to what the Nifty would in the subsequent time period (technically hard currency is also an investment!), after accounting for the transaction cost of switching. As far as I was concerned here, though, I still invest basically for kicks (don’t invest huge amounts). So it’s basically about spotting a potential boom, riding it and then moving out. Light touch investing.

There are times when I want to get back to the world of investment (as a professional). I have some unique ideas for fund management. Perhaps I should use my next break in billable work to flesh that out. For now, check out my only other post on investing – on why you should not track your portfolio too closely.