Category: Investing Insight

Investing insight to make you a better investor.

Indians Investing Abroad

Make LRS work for you

There are quite a few reasons why Indians would want to invest overseas. Education, retirement and emigration are frequently cited as top priorities. In the past, the only way to do this was through the Liberalised Remittance Scheme (LRS) route. However, with Indian mutual funds finally waking up to increasing demand from investors, does investing in international public market securities through this process still make sense?

Liberalised Remittance Scheme

The Indian Government, through its various regulatory and enforcement arms, have traditionally tried to keep Indians from sending money abroad. The problem has always been that populist policies used to win elections end up choking growth and stoking inflation. This leads to investors pulling funds away from India – aka, capital flight. One way to stem the tide is to try and trap Indian capital within India.

We use the word “try” because we are all aware about the hawala network that thrives to this day because of these policies. Thankfully, the process of liberalization has slowly, in baby steps, opened the doors for Indians to legally remit funds abroad.

The Reserve Bank of India (RBI) sets the rules governing these fund transfers that banks need to follow. And banks are supposed to report and track these transactions both at the individual and aggregate levels. Given the paperwork involved, most banks require you to make a trip to a “designated” branch office and execute the instruction in-person. The whole process is cumbersome, requires paperwork and takes an hour or two to complete.

Not only is LRS is painful, it is also expensive.

Most people fixate on bank fees and GST but that’s only part of the story. The biggest scam is the exchange rate given by the bank – it is the worst possible rate that they can give you while still being compliant with rules & regulations. If you compare the “google” rate with the final transfer rate, you’ll find that the drag is about 3%

So, why do it?

More Choice, Less Cost

The US ETF market went through a decade-long price war that drove vanilla cap-weighted fees to almost zero.

For example, if you want to invest in the S&P 500 index, then Vanguard’s VOO ETF charges you 3bps for the privilege whereas Motilal’s index fund charges 50bps. If you consider the tax differential and the transfer knee-cap, you break-even by year 7. So, if you are a passive, buy & hold investor with a long enough time horizon, LRS makes more sense.

While costs are important, so are choices. You can access strategies beyond what Indian mutual funds deign to offer in the local market. For example, there are a ton of factor strategies available through ETFs that are probably never going to be launched in India.


Previously:

ETFs for Asset Allocation

The United States of ETFs


Lower Transaction Costs

Indian policy makers love to ape Western European policies without giving a second thought to its appropriateness given our stage of growth. One such self-goal has been the STT – Securities Transaction Tax – that taxes transactions rather than profits. And yes, we tax both short-term and long-term capital gains. Sort of like a dare: We’ll see how you’ll make money trading.

Fortunately, the US has avoided shooting itself in the foot so far.

Lets say, you fall in the 30% income tax slab. You have a trading strategy that makes 20% returns in both markets. The strategy turnsover the portfolio “x” times. Given 0.01% STT in India and zero brokerage in the US, what is “x” for you to be indifferent in Year 1?

If you turn over your portfolio more than 60 times, you would be better off deploying that strategy in the US rather than India.

If you set the gross returns to zero, the required turnover drops to 30.

However, if you only trade infrequently, then LRS may not the best way to go. For example, a 40x turnover strategy will need 3 years to be indifferent.

Basically, if you are going to trade frequently, doing it in the US makes a lot more sense.

Caveats

LRS ensures that you will need a Chartered Accountant to do you taxes. You need to account for the dividends you have received, report your net personal assets, etc. So this route doesn’t make sense for small accounts.

If you don’t share your trading and banking passwords with your next-of-kin, then you need to be worried about US Estate laws. The U.S. has jurisdiction over U.S.-situated assets and requires executors for nonresidents to file an estate tax return if the fair market value at death of the decedent’s U.S.-situated assets exceeds $60,000. Directly investing in U.S.-situs assets as a non-U.S. investor creates potential U.S. estate tax liabilities.1

Conclusion

We feel that the LRS route is attractive both for a buy & hold investor as well as an active investor with an edge. However, one should get into it knowing the trade-offs involved.


If you are looking for simple, pre-canned investment strategies to invest in the US, check out freefloat.us


The United States of ETFs

Just can’t get enough.

For the longest time in the US, actively managed mutual funds ruled the roost. Then came Jack Bogle with his index fund and the ceaseless mantra of “costs and taxes matter” and the dynamic shifted, slowly at first and then suddenly, in favor of indexing. It was only a matter of time before people figured out the tax loophole of ETFs and now, there are over 2500 ETFs listed in the US.


Previously: ETFs for Asset Allocation


The Tax Loophole

Unlike in India, where mutual funds are “pass through,” US mutual fund investors pay capital gains tax on assets sold by their funds. When there are large-scale redemptions, say, during a market melt-down, funds are forced to sell their holdings. This generates capital gains taxes, meaning that investors have to pay tax on assets that had fallen sharply in value1.

ETFs​, on the other hand, don’t have to subject their investors to such harsh tax treatment. ETF providers offer shares “in kind,” with authorized participants serving as a buffer between investors and the providers’ trading-triggered tax events.

A Plethora

Of the ETFs that survive today, the number of launches every year has trended higher.

While Equity ETFs dominate launches, the share of fixed income, alternatives, etc. has increased as well.

Most of the AUM resides in “vanilla” strategies – typically market-cap based.

The winner HAS taken all

Plot the assets of each ETF, in billions, in log-scale and you can tell that this is a game of scale.

Of the total 2577 ETFs, 2022 (78.5%) have less than a billion dollars in assets. You need to filter for $10 billion and up to just see the x-axis.

The top 3 issuers: Blackrock, Vanguard and SSGA manage ~80% of all ETF assets.

Where there is an ETF, there’s an Index

Until last year, ETFs were supposed to be a “passive” entity. There were no “actively managed” ETFs. In order to be passive, an ETF needed to follow an index. And indices had to be rules based – however convoluted the rules. And issuers needed a third-party to provide the index.

The rise of ETFs (and passive investing, in general) put index providers in the middle of all the a action. They became a crucial cog in world finance that can make or break entire economies. So powerful, in fact, that China blackmailed MSCI to include its domestic stocks in its Emerging Markets Index, which is tracked by close to $2 trillion in assets2. And India has been working on inclusion of Indian sovereign bonds in global bond indices3.

We can see industry consolidation here as well. The top 5 index providers control ~75% of ETF AUM (more if you include index funds.) S&P Global and MSCI are as close to “pure-play” index providers as you can get and their stock market performance is off-the-charts.

Fee Squeeze and Innovation

The problem with index ETFs/funds is that buyers only care about two things: expense ratio and tracking error. This resulted in a massive fee war that saw the vanilla-passive industry consolidate around Blackrock and Vanguard. For example, Vanguard’s S&P 500 ETF’s expense ratio is 3bps.

So, what next?

International ETFs

The first wave was ETFs providing international diversification. However, the “home-bias” is pretty strong with AUM under international ETFs barely making a quarter of the total.

On a weighted average basis, these ETFs charge about 30bps. However, since these are mostly cap-weighted, the fee-war is just as intense here.

Leveraged/Inverse ETFs

Many investors have mandates that prevent them from trading derivates outright. This is especially true for Indian investors taking the LRS route to invest in the US. However, Wall Street has your back.

Leveraged ETFs give you 2x or 3x the daily returns of a benchmark index like the S&P 500 or the Nasdaq 100. Feeling bearish? Inverse ETFs do the opposite.

Caveat: These are NOT buy-and-hold investments and are more suitable for day-traders. The discussion requires a separate post.

On a weighted average basis, these ETFs charge about 100bps. While lucrative, they are mostly niche.

Active ETFs

An ETF’s tax-free wrapper make it an order of magnitude more attractive than an identical mutual fund. New issuers/managers have taken advantage of this and launched actively managed ETFs.

On a weighted average basis, active ETFs charge about 50bps. These are still early days for this category – they barely make 5% of total ETF assets. Liquidity and tracking errors during market crisis are yet to be tested.

Conclusion

There is a plethora of choices when it comes to ETFs in the US. If you plan to wander away from the plain-vanilla stuff, please take the time to read the prospectus and understand how it works.

If you are looking for simple, pre-canned investment strategies to invest in the US, check out freefloat.us

Global Equities Momentum

A slice of Dual Momentum

Gary Antonacci created the Global Equities Momentum (GEM) model that applied dual momentum to stock and bond indices. It toggles between stocks and bonds using 12-month trailing returns. And when it toggles to “stocks,” it chooses between US equities and International (ex-US) equities based on whichever posted higher returns in the previous 12-months. The model uses the S&P 500 index as a stand-in for US equities and the WORLD ex USA index for international stocks.

Investors can use the ETFs SPY/VOO for the S&P 500, SCHF for World ex-US DMs and AGG for bonds while replicating this strategy.

The best part about this strategy is its simplicity. It takes just 3 inputs and anybody can set it up on Google Sheets. Execution is as simple as it gets because at any given point in time, it is long just one ETF. Also, given that it uses a 12-month look-back, it is less prone to whiplashes, resulting in a lower trading frequency.

Specifications & Expressions

When you automate systematic strategies, you need to nail down its exact specifications. In this case, they are mainly: inputs, look-back periods and traded instruments.

The original version of the Strategy uses the S&P 500 and World ex-US both for inputs and as proxies for the traded instruments. However, there is no reason why they both should be the same. Also, what is so magical about a 12-month look-back period anyway? Why can’t it be 6 -months, a month or an average of the last 6-months?

The Strategy only describes a broad idea with one set of Specifications and Expressions out of a multitude. It can (and should) be adapted to fit one’s risk profile and investment horizon.

The Momentum Expression

The easiest tweak to the original strategy is to swap out the traded equity instruments with their momentum counterparts.

At the final step, when it comes to executing the trade, you can use MTUM, the US Momentum ETF instead of SPY/VOO and IMTM, the DM ex-US Momentum ETF instead of SCHF.

Long-only momentum ETFs are highly correlated to their market-cap counterparts but have the potential to juice returns in bull-markets. Since we are trend-following anyway, why not go a step further up the risk-curve and embrace momentum as well?

This is the basic idea behind our Global Equities Momentum I strategy.

The Look-Back Specification

Picking a look-back for trend-following strategies is fraught with data-mining bias. One could potentially test 100s of periods and pick one that gave the best results historically. The data-mined look-back could even work in forward tests but inexplicably, and suddenly, fail in real portfolios.

The safest thing to do would be to not change the look-back periods outlined in the original research. However, the world would’ve changed since its first publication. How do you strike a balance between the two?

This is what we’ve tried to do in our Global Equities Momentum II strategy.

Long look-backs are slow at reacting to rapidly changing markets. Some might say that this is a bug while some might argue that this is a feature. Shorter look-backs, on the the other hand, can react faster but are prone to head-fakes and whiplashes.

The second version of our GEM strategy tries walk the fine line by taking the average of 6- through 12-month returns. It tries to hew close to the original research while acknowledging that the world has gotten faster since it was first published.

No Free Lunch

While the strategy adapts to the broad, slow-moving macro theme of US equity under-performance vis-à-vis rest-of-the-world (were it to occur,) it is not immune to getting whiplashed due to short and steep market dislocations like the COVID crash of March 2020. The strategy got into bonds just when the equity markets were recovering and stayed there until well-after. It is simply not possible to avoid all landmines when it comes to investing.

While we ran our back-tests, we tried a fair amount of permutations and combinations. Some where discarded in spite of having better risk-adjusted returns because they lacked internal consistency. While some slipped into data-mining territory in spite of our best efforts to avoid it. Readers interested in the process and the code can read through our GEM Collection.



Related: ETFs for Asset Allocation

Synthetic Indices

Popular indices, like NIFTY 50 & MIDCAP 150, are useful if you are benchmarking long-only portfolios. However, if you have a long-short portfolio, then you need a long-short benchmark.

When Are Contrarian Profits Due To Stock Market Overreaction? (Lo, MacKinlay, 1990) describes a naïve portfolio construction process that is fit for purpose.

For momentum, portfolio weights are in proportion of excess returns over an equal-weighted index and for mean-reversion, they are the inverse.

For example, if you subtract the returns of each of the components of the NIFTY 50 index with the returns of NIFTY 50 EQUAL-WEIGHT index and divide by 50, you end up with the portfolio weights for the next day. Each look-back period used to calculate returns will produce a different set of weights (and a different synthetic index.)

As impractical as constructing such a portfolio may seem, they are useful as a benchmark for long-short mean-reversion/momentum portfolios. Here are index returns since April 2020 with 20- and 50-day look-backs.

This is especially interesting if you are looking at market dislocations and subsequent recoveries. Here are indices since June 2019 with 5-, 20- and 50-day look-backs.

Counter-intuitively, naïve mean-reverting long-short seems to out-perform momentum.

ETFs for Asset Allocation

Building blocks for a diversified portfolio

Over the last few years, most brokers in the US have started offering no-frills accounts with zero-brokerage and fractional shares. However, new investors who are just getting started are either over-served by advisors or under-served by social media. In this post, we list out ETFs that every investor should be aware of if they are interesting in building a diversified portfolio.

We filtered for

  • Assets under management (AUM) – larger the better

  • Cost (expense ratio) – lower the better

  • Liquidity and popularity – higher the better

We cover equities, bonds, real-estate and commodities across the US, DM (Developed Markets) and EM (Emerging Markets.)


VTI

The Vanguard Total Stock Market Index Fund ETF is a $250 billion whale of a fund that is probably the only equity ETF a small-ticket first-time investor should consider.

Covering the entire US equity market, it is as passive as they come. With an expense ratio of 3bps (you pay $3 for every $10,000 investment,) it is the cheapest as well.

ETF, Vanguard

AGG

The iShares Core U.S. Aggregate Bond ETF is one of the largest bond ETFs on the planet with $90 billion in assets. It has everything from treasuries, agencies, CMBS and ABS to investment-grade corporates. You pay 4bps for the privilege.

Split your funds 60% into VTI and 40% into AGG and you basically have a portfolio that has traditionally outperformed 99% of the hedge funds out there.

ETF, iShares


With the Big Two out of the way, if you still have some risk appetite and time on your hands, you can reach out for more returns (potentially.)

SCHF

The Schwab International Equity ETF tracks all Developed Markets other than the US. With an AUM of $27 billion and an expense ratio of 6bps, it is a decent equity fund if you feel that US stocks are over valued.

Its largest exposure is to Japanese stocks followed by British, France, Germany, Canada and Switzerland. Unlike some other funds in this space, it also includes South Korea.

One caveat though, the fund is not currency hedged. The topic of buying hedged vs. unhedged ETFs is a topic that we will not get into right now. Suffice to say that hedging is not free – it is a price you pay to insulate yourself from fluctuations and you should weigh the cost vs. its benefits over your investment time horizon.

ETF, Schwab

BNDX

The Vanguard Total International Bond ETF provides exposure to Developed Market (ex-US) investment-grade government and corporate bonds. It is a monster of a fund with $136 billion in assets. An 8bps expense ratio is a wonderful bargain.

The fund is currency hedged.

ETF, Vanguard


We are not fans big fans of EM/FM (Emerging/Frontier Markets) investing from the US through ETFs. In the recent past, these markets have only been a source of risk and not returns. Gains in local currencies, when converted to US Dollars, haven’t compensated for the additional risk. However, for investors who believe that the future is going to be different, these ETFs are worth considering.

EEM, EMXC and FRDM

The iShares MSCI Emerging Markets ETF is perhaps the largest in this space. $32 billion in AUM and a 70bps expense ratio, it is the go-to ETF for EM investors.

However, the wrinkle is that Hong Kong and China form more than 37% of the portfolio. For investors worried about geopolitical risk, this may be a point of concern. This is where EMXC comes in.

The iShares MSCI Emerging Markets ex China ETF is a minnow by comparison (less than $1 billion in AUM) but it doesn’t include China and Hong Kong, making it palatable. However, there’s another wrinkle while investing in EM – some of those countries are ruled by despots. What if you want to invest in EMs that are democratic and respect personal freedom? Enter FRDM.

The Freedom 100 Emerging Markets ETF tracks the Life + Liberty Freedom 100 Emerging Markets Index. The Index is a freedom-weighted EM equity strategy that uses human and economic freedom metrics as primary factors in the investment selection process. And this means excluding China, Hong Kong and India – 3 of the largest markets in EM.

ETF, iShares

EMB

The iShares JP Morgan USD Emerging Markets Bond ETF an index of US-dollar-denominated sovereign debt issued by EM countries. It holds USD-denominated rather than local-currency debt. This eliminates direct currency risk for US investors. With $20 billion in AUM and an expense ratio of 39bps, its an attractive fund for investors looking to diversify into EM bonds.

ETF, iShares


Now that we have equities and bonds out the way, lets look at real estate. A REIT is a publicly traded security that invests in real estate through properties or mortgages. For the most part, in the past, their returns were correlated to interest rates. From investopedia: In a study done by the S&P, which analyzed six periods beginning in the 1970s where the yield of the 10-year Treasury grew significantly, of these six periods of interest rate increases, REIT returns increased during four of them.

VNQ and VNQI

VNQ, The Vanguard Real Estate ETF has about $75 billion in AUM and charges 12bps. It captures much of the US real estate market.

VNQI, Vanguard Global ex-U.S. Real Estate ETF has about $5 billion in assets and an order-of-magnitude larger than the closest alternative. It contains property companies from both developed and emerging countries, excluding the United States. Japan, China and Hong Kong are the top three geographies where it invests. Like with any other EM/FM investments, caveat emptor!


Some investors view gold as a tail-risk and inflation hedge and some prefer to add commodities to their portfolio to ride on emerging market demand. While it is debatable whether these assets live up to their expectations in the future, there have been lengthy stretches in the past where gold and commodities have outperformed other asset classes.

GLD and PDBC

GLD tracks the gold spot price, less expenses and liabilities, using gold bars held in London vaults. With about $65 billion in management and 40bps in expense ratio, its probably the best way to add exposure to the yellow metal in your portfolio.

PDBC holds a diverse basket of futures contracts on 14 commodities across the energy, precious metals, industrial metals and agriculture sectors. Has about $6 billion in AUM and its 59bps expense ratio is a bargain compare to the effort involved in actively managing a futures portfolio in a tax-efficient manner.


There are over 2500 ETFs listed in various US stock exchanges. We hope that our short list of 12 ETFs above helps investors get started. Do watch the discussion below:


Already have a basic portfolio and looking for quantitative strategies on US stocks and ETFs? Head over to freefloat.us