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Bet on quality funds amid slowing economic growth, market turbulence

Quality indices, such as the Nifty 500 Quality 50 Index, are built by filtering stocks from the parent index based on their quality score

Mutual Funda

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Himali Patel

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WhiteOak Capital Mutual Fund recently launched the WhiteOak Capital Quality Equity Fund. The new fund offer is India’s first actively managed quality fund. Several passive funds which replicate quality indices already exist.
 
Understanding the quality theme
 
The quality factor focuses on robust companies. “These are companies with good management, an established track record of business performance, consistent and predictable cash flows, and visibility of revenues. They also have proven business models. These attributes make them less risky and allow them to command higher valuations,” says Chintan Bhatt, director, managed solutions, Waterfield Advisors.
 
Quality stocks score high on a few parameters. “Key metrics for assessing quality include sound return on equity (RoE), low debt-to-equity ratio, stable earnings growth, and strong free cash flow. Good governance and management with strong execution capability are also critical parameters,” says Ramesh Mantri, chief investment officer (CIO), WhiteOak Capital Asset Management Company (AMC).
 
 
Quality indices, such as the Nifty 500 Quality 50 Index, are built by filtering stocks from the parent index based on their quality score. “The quality score is based on parameters like RoE, financial leverage ratios, and variability in earnings per share (EPS) growth,” says Feroze Azeez, deputy chief executive officer (CEO), Anand Rathi Wealth.
 
Why invest now?
 
Quality funds are a good bet amid slowing economic growth. “These financially sound companies exhibit resilience during periods of economic and market uncertainty, as witnessed from the second half of 2024,” says Mantri.
 
The theme performs well in a low earnings growth environment. “A fall in earnings pushes investors towards quality stocks,” says Bhatt. He adds that quality also thrives during periods of low interest rates, high leverage, and unforeseen global risks.
 
The theme’s recent underperformance makes it appealing. “Quality has underperformed over the past four years, so we are getting more positive on this theme,” says S. Naren, executive director and CIO, ICICI Prudential AMC. Bhatt notes that quality indices are trading below their long-term averages.
 
Mantri points out that the Nifty 200 Quality 30 Total Return Index (TRI) outperformed the Nifty 200 Value 30 TRI by 2 percentage points compounded annually over the past 20 years.
 
Potential downsides
 
Investors should be prepared for periods of underperformance. “Quality funds underperform during periods of strong market momentum driven by sectors that respond to macros and policy changes, or when markets bounce back from an economic downturn,” says Mantri. The value factor delivered twice the return of the quality factor over the past four years.
 
According to Azeez, quality stocks struggle in high interest rate environments, when their valuations come under pressure.
 
Active or passive?
 
Currently, 20 quality-themed funds are available, of which 19 are passive and one active. The active fund from WhiteOak Capital aims to outperform quality indices, while passive funds seek to match index returns.
 
Passive products are typically large-cap focused and rely on historical data. “An active fund can take a forward-looking view of quality businesses,” says Mantri. Active funds can also incorporate qualitative assessments, unlike passive funds, which replicate indices built purely on data.
 
“Indices undergo rebalancing once every six months, forcing investors to stay invested in underperforming companies,” says Azeez.
 
The Indian equity market’s growth stage presents opportunities for fund managers. “There are ample opportunities for fund managers to generate alpha, which investors should capitalise on,” says Azeez.
 
However, Bhatt advises caution with the new active fund. “Invest in it once some track record is available. For now, stick to passive quality funds,” he says. 
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First Published: Jan 13 2025 | 10:14 PM IST

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