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The index—Nifty Smallcap 250 Momentum Quality 100—has been created by National Stock Exchange (NSE) based on discussions with Mirae Asset MF. Mirae Asset Nifty Smallcap 250 Momentum Quality 100 ETF—an exchange traded fund, or ETF—will aim to mimic the performance of the index, which will be reviewed and re-balanced every six months. Depending on how the stocks have performed on liquidity, quality and momentum factors, there will be inclusion and exclusion from the index.
Alternative index
Unlike regular passive funds that simply stick to existing market indices, factor-based or smart-beta funds involve construction of an alternative index.
For instance, the regular Nifty Smallcap 250 Index simply consists of the top 250 small cap stocks on the basis of market capitalization. With the help of different factors, a new basket of 100 stocks will be created out of the Nifty Smallcap 250 Index. The least liquid stocks will first get filtered out and then a composite score of quality and momentum will determine the 100 stocks that finally make the cut in the new index: Nifty Smallcap 250 Momentum Quality 100 .
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“About 30-40 stocks will get eliminated after applying the liquidity filter. The remaining stocks will be assessed on a composite score (average) of quality and momentum factors. Quality factor will look at various company fundamentals such as financial leverage, earnings stability, consistency of profit growth, return on equity. Momentum factor will look at risk-adjusted six-month and 12-month performance,” explains Swarup Mohanty, chief executive officer of Mirae Asset MF.
Liquidity parameters, along with composite score of quality and momentum, will determine whether the same stocks remain in the index or get replaced during the semi-annual review.
What works
Small-cap stocks tend to be a lot more volatile than large- and mid-cap stocks. During phases of market correction, such stocks tend to see heavy selling pressure.
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Constructing a universe of stocks with quality factor can potentially limit the downside. Mirae’s back-testing of the index shows that it tends to fall less than Nifty Small Cap 250 Index during market corrections.
NSE data suggests the same. For example, during the 2008 financial crisis when the Nifty Small Cap Index 250 fell by 69%, the Nifty Small Cap 250 Quality Momentum 100 fell by 67%. In calendar year 2013, which was a tepid year for small-cap stocks, the Nifty Small Cap 250 Index fell by 9%, while the Nifty Small Cap 250 Quality Momentum 100 rose by 8%. In 2018, when just select large cap stocks performed, the regular small cap index was down 27%; the Nifty Small Cap 250 Quality Momentum 100 was down by 19%. On the other hand, a momentum factor should help this index perform better than the regular small-cap index during broad market rallies.
“This is a better way to index investing. When you combine these factors, you get a more focused strategy, instead of the entire index. Retail investors can consider investing in this ETF, but only through systematic investment plans (SIPs) as the small- cap valuations appear expensive right now,” says Kavitha Menon, founder of Probitus Wealth.
In small caps where volatility can be high, SIPs can help investors buy more units when stock prices fall and lesser units when stock prices rise. Result: lower average purchasing cost. Investors can use the fund of fund structure of the ETF for making their SIP investments.
What doesn’t work
Mutual fund experts say a well-run actively-managed small-cap fund can still generate significant outperformance over the benchmark index.
“Unlike large-caps where funds have found it difficult to beat the benchmark returns, the scope for generating outperformance remains significantly higher in small-cap space. In any case, a well-managed small-cap fund will also look for liquid and quality stocks. But, this index also follows momentum factor, which is generally avoided by actively-managed funds,” points out Kirtan Shah, founder of Credence Wealth Advisors.
Shah adds that quality and liquidity factors may not be enough to steer clear of companies with bad corporate governance. “In small-caps, you need fund managers to go beyond just the quantitative factors, to filter out companies where corporate governance practices and management quality might be questionable. However, for those who just want to do index investing in small-caps, such a factor-based index is still a better alternative,” Shah points out.
What should investors do?
An overlay of quality and momentum factor on the small-cap index can work well for returns. Past data shows that it has done better than regular small cap index during downturns and even in broad market rallies, but can it do so in future? Only time will tell.
Till this ETF builds a track-record, investors can stick to actively-managed funds in the small cap category with a solid long-term track record across different market cycles.
Remember, this is a highly volatile category. So, use SIPs to stagger your investments. Small-cap funds can be used to diversify your core portfolio, but make sure your exposure to small-cap funds stays within your risk-tolerance levels.
The new fund offer period is open till 21 February.