The index – Nifty Smallcap 250 Momentum Quality 100 – has been created by the 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 rebalanced every six months. Inclusions and exclusions in the index will occur depending on how the stocks have performed on liquidity, quality, and momentum factors.
Alternative index
Unlike regular passive funds, which are simply linked to existing market indices, factor-based or smart-beta funds involve the creation of alternative indices.
For example, the regular Nifty Smallcap 250 index consists of the top 250 small-cap stocks based on market capitalization. With the help of various factors, a new basket of 100 stocks will be created from the Nifty Smallcap 250 index. The least liquid stocks will be filtered first and then an overall score of quality and momentum will determine the 100 stocks that will ultimately cut into the new index: Nifty Smallcap 250 Momentum Quality 100.
“Around 30-40 stocks will be eliminated after implementing the liquidity filter. The remaining stock will be evaluated on the overall score (average) of quality and speed factors. The quality factor will look at various fundamentals of the company such as financial leverage, earnings stability, sustainability of profit growth, and return on equity. The momentum factor will look at risk-adjusted six-month and 12-month performance,” explains Swaroop Mohanty, chief executive officer, of Mirae Asset MF.
The liquidity parameters, along with the overall score of quality and momentum, will determine whether the same stocks remain in the index or are replaced during the half-yearly review.
What works
Small-cap stocks are much more volatile than large- and mid-cap stocks. During market correction phases, such stocks see heavy selling pressure.
Creating a universe of stocks with quality factors could potentially limit the downside. Back-testing of Mirae’s index shows that it falls less than the Nifty Small Cap 250 index during market corrections.
NSE data also shows the same. For example, during the 2008 financial crisis when the Nifty Small Cap Index 250 fell 69%, the Nifty Small Cap 250 Quality Momentum 100 fell 67%. In calendar year 2013, which was a sluggish year for small-cap stocks, the Nifty Small Cap 250 index fell 9%, while the Nifty Small Cap 250 Quality Momentum 100 rose 8%. In 2018, when select large-cap stocks underperformed, the regular small-cap index was down 27%; Nifty Small Cap 250 Quality Momentum 100 was down 19%. On the other hand, a momentum factor should help this index outperform the regular small-cap index during broader market rallies.
“This is a better way of index investing. When you combine these factors, you get a more focused strategy rather than an entire index. “Retail investors can consider investing in this ETF, but only through systematic investment plans (SIPs) as small-cap valuations look expensive right now,” says Kavita Menon, founder, Probitus Wealth.
In small caps where volatility may be higher, SIP can help investors buy more units when stock prices fall and fewer units when stock prices rise. Result: Lower average purchasing cost. Investors can use the fund structure of ETFs for their SIP investments.
what doesn’t work
Mutual fund experts say a well-run, actively managed small-cap fund can still significantly outperform the benchmark index.
“Unlike large-caps, where funds have found it difficult to beat benchmark returns, the scope for generating outperformance in the small-cap sector is much greater. In any case, a well-managed small-cap fund will also look for liquid and quality stocks. But, the index also follows the momentum factor, which is generally avoided by actively managed funds,” explains Kirtan Shah, Founder, of Credence Wealth Advisors.
Shah says quality and liquidity factors may not be enough to stay away from companies with poor corporate governance. “In small-caps, you need fund managers to go beyond just quantitative factors, to filter out companies where corporate governance practices and the quality of management may be questionable. However, for those who just want index investing in small-caps, such factor-based indices are still a better option,” explains Shah.
What should investors do?
A mix of quality and momentum factors can work well for returns on the small-cap index. Past data shows that it has outperformed regular small-cap indexes during recessions and even in broad market rallies, but can it do so in the 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 solid long-term track records across different market cycles.
Remember, this is a highly volatile category. Therefore, use SIP to manage your investments. Small-cap funds can be used to diversify your core portfolio but ensure that your exposure to small-cap funds remains within your risk-tolerance level.
The new fund offer period is open till February 21.