To generate alpha, investors should opt for factor-based funds: Experts

As they have a short history, take only a small exposure to these funds initially in your satellite portfolio

Several factor-based index and exchange-traded funds (ETFs) have been launched in India based on strategies like low volatility, value, equal weight, quality, momentum and so on. Since these products have been around for only a short while, experts suggest investors should begin by taking a small exposure to them, which they may increase as they gain confidence.

Market cap-based funds can suffice

Some advisors only suggest pure passive, market cap-based index funds. Says Avinash Luthria, a Sebi-registered investment advisor and founder of Fiduciaries: “A Nifty50 index fund via a direct plan with fees of 0.1 per cent (10 basis points) is the only domestic equity mutual fund that investors require.” His logic: A Nifty50-based fund offers exposure to a diversified basket of stocks at a very low fee. The benefit of low fee, he says, adds up over the long term, making such a fund difficult to beat. “The expense ratios of factor-based funds are higher than that of a low-cost Nifty-based fund. Also, it is impossible to predict which factor fund will outperform a Nifty50 fund,” says Luthria.

Boost returns

Fund managers say investors should decide between a market cap-based index and a smart beta index based on their portfolio return requirement and risk profile. “A smart beta fund, through its rule-based approach, attempts to provide better risk-adjusted returns than a traditional index fund,” says Chintan Haria, head-product and strategy, ICICI Prudential Mutual Fund. The new fund offer for ICICI Prudential Nifty Low Volatility 30 ETF Fund of Fund closes on Tuesday.

The purpose of a factor-based fund is to beat market returns. “By applying certain rules to a broad parent index, fund houses create a narrower index which they believe can beat the market over the long term,” says Vidya Bala, co-founder, Primeinvestor.in.

Some advisors say they are willing to bet on such rule-based options. “Research by S&P Dow Jones Indices has shown that strategies like momentum, quality, and low volatility have done well in India in the past,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Sebi-registered investment advisor.     

Factor-based funds can also be combined with market-based indices to reduce portfolio risk. “Indices like Nifty50, Nifty500, etc, are growth oriented. They can be combined with low volatility and value indices to cushion downside risk,” says Bala.   

Short on track record

Factor-based indices have been around for a short while in India. Market cap-based indices have a long track record. They have stood the test of time, which is why financial advisors have greater confidence in them.  Experts say investing in factor funds based on back-tested data alone can be risky. Fund houses have the option of picking an index (from the many available) that shows good past performance and launch a fund based on that. Whether such a fund will perform in actual market conditions is hard to predict.   

Fit into satellite portfolio

In your core portfolio, combine a Nifty50-based fund with a Nasdaq/S&P 500-based fund. In the satellite portfolio, where the aim is to generate alpha, combine domestic active funds with factor-based funds. “Take a 5 per cent exposure to each factor-based fund initially. Enhance exposure at the expense of active funds as you gain confidence in them,” says Raghaw. Invest with a five to seven-year horizon and hold on during the inevitable spells of underperformance.