An ETF or equity-diversified fund?

Wouldn't it be a dream-come-true if your fund manager had a formula to beat markets consistently? Motilal Oswal Asset Management Company's (AMC's) first offering plans to achieve just that.

Just like an index fund, the new scheme – MOSt Shares M50 – will imitate an index in terms of the shares being held. That is, the scheme will ape the National Stock Exchange's S&P CNX Nifty by holding scrips that comprise the index.

The difference is that the scheme will give weights to stocks on the pattern of Motilal Oswal AMC’s proprietary model, based on companies’ fundamentals and not market capitalisation.

The ‘enhanced Nifty index’ assigns more weights to stocks that are fundamentally stronger than its peers, based on return on equity, net worth, retained earnings and price. “If we follow the Nifty just like any other index fund, we will have to allocate more capital to companies with high weight in the index, even if their valuations are expensive. We will face a similar handicap if undervalued companies have lower weight. This is contrary to sound investing principles,” said Nitin Rakesh, managing director and CEO, Motilal Oswal AMC.

While moving away from the tried-and-tested model of basing the exchange-traded fund on the index, both in terms of stocks and their respective weights, is the unique selling proposition of the scheme. This might also be its shortcoming.

Will it work?
The lack of a benchmark is something most financial planners rue. Also, an algorithm-based model with no historical record leads to scepticism. One does not know if the model will work and, more important, in what kind of circumstances.

MOSt Shares M50’s underlying index is proprietary and an intellectual property. Due to this, it is impossible to know how the index will work. “This is another reason to let the fund prove it’s worth first before an investor puts money in it,” said Malhar Majumder, a certified financial planner.

Examples of funds based on algorithms are Religare Agile, which has given one-year returns (as on June 24) of 21.33 per cent and Reliance Quant Plus, which has given returns of 23.47 per cent. The one-year average return from the equity-diversified category is 34.06 per cent. The best performing fund, ICICI Prudential Discovery, has returned 69.47 per cent in the period.

The fund house will also make changes to the underlying index when a company moves in and out of Nifty, as it wants to have only index stocks. If the AMC feels the portfolio is getting too concentrated, it will rebalance the index to diversify it. This will be done if the weight of a single company crosses 19.99 per cent or the total weight of stocks with over five per cent weight crosses 49.99 per cent. “This essentially makes it an equity-diversified fund,” said Suresh Sadagopan, a certified financial planner.

The scheme will also take derivatives exposure while rebalancing the portfolio, to avoid fluctuation of the portfolio. “The total exposure to derivatives will be restricted to 10 per cent of the net assets of the scheme,” said Rakesh.

Conceptually, the investment model of this fund may appear robust enough to achieve its objective. However, it is tested on historical market data. This could be an issue, as stock markets do not necessarily repeat their behaviour. A classic example is the correction of 2008. Many algorithms failed during this. For an investor, either treat it as a large cap or an equity-diversified fund, or adopt a wait-and-watch policy.