The power of factor-based index funds

The downside resilience in a volatile market is a selling point.

In the realm of investment, index funds stand out as a cornerstone strategy for investors seeking a straightforward and cost-effective approach to market exposure. These funds function by mirroring the performance of a specific market index, such as the Nifty 50 Index. In contrast to actively managed funds, index funds operate passively, replicating the movements of the chosen benchmark. This method of investment, over the past few years, has become increasingly popular among the masses. 

Index funds’ popularity is grounded in their notable advantages. Their simplicity, in contrast to actively managed funds, appeals to investors of varying experience levels, minimising the need for constant monitoring. Cost-effectiveness is a pivotal factor, as index funds incur lower fees due to minimal management, attracting those conscious of maximising returns. Transparency is a key advantage, enabling investors to easily track performance and comprehend their investment composition. Furthermore, inherent broad market diversification mitigates risks associated with individual stock selection, contributing to a more resilient investment portfolio. These collective attributes make index funds an attractive and accessible choice for a diverse range of investors.

Various types of index funds cater to diverse investment objectives. Market cap-based funds offer broad exposure by replicating overall market performance, while sectoral funds focus on specific industries for more targeted investments. Factor funds, also known as smart beta or strategic beta funds, adopt a nuanced approach. Factor funds deviate from traditional market-cap weighted indices by systematically exploiting specific factors like macroeconomic indicators, style factors, and fundamental metrics to enhance returns or manage risks, providing investors with a sophisticated alternative to traditional indices.

This strategy aims to systematically capture nuanced performance variations, offering a more evolved and strategic investment approach. Factor-based investing’s appeal lies in its potential to enhance returns and mitigate risks by strategically weighting portfolios based on historical outperformance indicators, providing investors with a nuanced understanding of factors influencing asset performance. A subset of factor investing is the value factor strategy, focusing on undervalued stocks. 

Nifty 50 Value 20 Index

The Nifty 50 Value 20 Index is a benchmark index that embodies the value factor. This index comprises the 20 most liquid-value blue-chip companies listed on the National Stock Exchange (NSE). The methodology used for this index involves a systematic selection process based on criteria such as Return on capital employed, price earnings ratio, price to book value ratio, and dividend yield.

This offering is designed to replicate the performance of the Nifty 50 Value 20 Index. In essence, this fund adopts a disciplined investment approach, strategically investing in the 20 value stocks from the Nifty 50 universe. The systematic stock selection process is complemented by periodic rebalancing, ensuring that the portfolio aligns with the underlying index.

Why investing in this index? 

Firstly, in elevated market conditions, value investing as a style tends to do well. This is because the focus is always on picking stocks which offer value amidst the elevated market conditions. 

Second, over a full market cycle such an approach helps to deliver better downside resilience and has the potential to outperform broader market indices. This strategic approach has demonstrated the potential for enhanced returns, as evidenced by its outperformance in 9 out of the past 11 years compared to the market cap-based index.

Third, by tracking the top 20 most value oriented blue-chip companies, the scheme offers wealth creation opportunities for investors. Historically, the Nifty 50Value 20 Index has outperformed the Nifty 50 Index on 1-year, 3-year, and 5-year periods with lower volatility and better downside risk limitation as compared to Nifty 50.

Fourth, the periodic rebalancing of the portfolio ensures that the fund adapts to changing market conditions, maintaining its alignment with the Nifty 50 Value 20 Index. The fund employs rule-based investing and periodic rebalancing, emphasising risk mitigation. This adds an extra layer of prudence to the investment strategy. 

In conclusion, if you are an investor looking to allocate a portion of your portfolio to value style of investing, then investing in an offering based on the Nifty 50 Value 20 Index can be a good starting point.

(The writer is Principal - Investment Strategy, ICICI Prudential AMC)