Introduction to investing in rules-based funds

Although most investors refer to passive funds as Nifty or Sensex based funds, there are hundreds of indexes available in the market to invest in. There are mid-cap, small-cap, multi-cap, commodity, international and debt-based. Index funds and exchange traded funds (ETFs). Though new to investors, these categories have garnered good interest from investors over the years.

However, there is a new category that is expected to make way in the next few years. They are called rules-based funds. What are they?

Rule-based funds are funds where the stock is selected based on pre-determined rules. There is no human intervention and hence no bias in how the stocks are selected. Rules are the holy grail, and the performance of wealth is purely dependent on the set of rules.

For example, someone who wants to filter out all companies with profit margin of 40% or more can easily do so in 500 Nifty companies. The result would be, say, 25 companies that can be invested. This is a very simple rule. In fact, there are many rules designed to be stock selection.

These rules-based funds are a huge success outside India. For example, in the US, these funds are expected to be $3.4 trillion by the end of 2022 (which, for comparison, exceeds India’s GDP of $3.1 trillion).

For investors, there are two main types of rules-based funds: quant funds and others called factor funds. The difference between them is transparency.

Quant funds are governed by rules – but rules are a secret sauce and are therefore mostly kept secret. Leaving the rules out would mean that the strategy could be easily replicated and therefore the owner of the strategy would not be able to sell it effectively.

Another type of rule-based fund are factor funds. These funds are 100% transparent and hence, investors looking for transparency can opt for these funds. Factor funds fall between active and passive funds.

Unlike Nifty 50 or Sensex index funds, where the objective is to track the performance of the benchmark, factor funds are built to beat broad benchmarks such as Nifty 500 or Nifty Mid-cap 150.

Globally the most popular factors are based on styles such as speed, price, low volatility and quality. Momentum Factor Fund selects the stocks that have the most momentum (ie, price appreciation).

A value fund selects stocks that have the most attractive valuation (measured by price/earnings or value/book value).

Low volatility funds provide access to stablecoins and quality funds choose stocks based on long-term profitability, among other things.

Thus Factors provides investors with a transparent rules-based stock selection process at a low cost. Is Factor Fair Better Than Index Funds?

In the current investment climate, factors are being sold as funds that outperform the benchmark but in reality, this is not always the case. Like all managed funds, there are moments when factors outperform the index and many times they do not.

However, in the long run, factor funds have outperformed indexes over the past 10-15 years, especially in terms of speed, low volatility and quality. Investors buying into the strategy should expect these strategies to underperform from time to time, so they are advised to hold on to the longer term.

Finally, investors looking to build a portfolio that has the potential to beat broad benchmarks (with transparency and low cost) should look for rules-based investing. However, investors should control expectations and remember that these strategies will also have periods of underperformance (like any other managed fund).

Prateek Oswal is Head (Passive Fund), Motilal Oswal AMC and Chief Executive Officer of Glide Invest.