Quality theme fund: Invest for long-term steady compounding, lower downside

Quality funds tend to be less volatile and offer downside protection and often perform better in a bear market due to the stable earnings

The new fund offer (NFO) of ICICI Prudential Quality Fund, an actively managed scheme, is open until May 20. WhiteOak Capital Mutual Fund, too, offers an active fund based on the quality theme. A large number of other asset management companies (AMCs) offer passive, smart-beta funds based on the quality theme.

 

These funds invest in high-quality companies. “They invest in companies with high return on equity (RoE), low debt-to-equity ratio, and consistent earnings growth,” says Feroze Azeez, joint chief executive officer (CEO), Anand Rathi Wealth.

 

More resilient, less volatile

 

Quality funds tend to be less volatile and offer downside protection. “They can help stabilise the overall portfolio. They often perform better in a bear market due to the stable earnings and strong balance sheets of the underlying stocks,” says Satish Dondapati, fund manager–exchange traded fund (ETF), Kotak Asset Management Company (AMC).

 

Over the past twenty years — from April 2005 to March 2025 — the Nifty 200 Quality 30 TRI delivered a compounded annual return of 18 per cent, compared to a 14.4 per cent return for the Nifty 200 TRI. “Quality funds have not only outperformed, they have done so with lower volatility, offering investors superior risk-adjusted returns,” says Ihab Dalwai, senior fund manager, ICICI Prudential AMC.

 

Quality funds reduce risk. “They avoid companies with excessive leverage, volatile earnings, or poor management, which reduces downside risk,” says Mohit Gang, co-founder and CEO, Moneyfront. 

  Premium valuations 

High-quality stocks often trade at a premium. “This can limit upside and make them sensitive to interest rate changes or valuation compression,” says Gang. Dondapati adds that these stocks are prone to correction if growth expectations fall short. Quality funds typically exclude younger, high-growth firms lacking long-term profitability data due to which they can miss out on high-growth opportunities and on companies poised for turnaround. Azeez points out that the category has a limited performance history. 

 

Right time to enter

 

Fund managers believe this is a good time to enter quality funds. “Over the past five years, quality names have underperformed broader markets, meaning many are now available at attractive valuations. With global economies grappling with geopolitical tensions, high debt burden and slowing growth, companies with sustainable earnings and solid balance sheets are best positioned to navigate volatility,” says Dalwai.

 

These funds suit investors seeking a stable core allocation to complement other styles like growth and value. “People with a time horizon of five years or more, who want to benefit from steady compounding and reduced drawdowns during market downturns, may consider these funds,” says Gang.

 

Passive or active?

 

Active funds can deliver alpha by selecting undervalued quality stocks. “They can also adjust their portfolios quickly depending on changes in market circumstances,” says Dondapati. However, they carry higher fees, and their performance depends on the fund manager’s skill.

 

Passive funds track indices that select stocks based on metrics like RoE and stable earnings. “Their advantage is lower fees, broad exposure, and no fund manager bias. However, these funds are less flexible — they cannot change their stocks swiftly if there is a sudden shift in the market, or if they underperform,” says Dondapati.

 

Quality funds may serve as a core equity holding as they offer growth, stability, and risk management, according to Gang. He recommends a 10–30 per cent allocation based on age and risk appetite.