A quality strategy can reduce risk in the mid-cap universe of 150 stocks

Enter gradually, raise exposure once funds have developed track record

The new fund offer (NFO) of DSP Nifty Midcap 150 Quality 50 Exchange Traded Fund (ETF) is on currently. UTI Mutual Fund has also applied to the Securities and Exchange Board of India for launching an index fund based on the same benchmark. These funds will try to replicate the performance of an index derived by applying a few quality filters to the entire mid-cap universe of 150 stocks.

Quality filters

Three criteria have been applied for selecting the 50 stocks in the Nifty Midcap 150 Quality 50 Total Return Index— return on equity (RoE), exclusion of highly leveraged stocks, and includes stocks that have displayed consistency in earnings growth.

Pursuing a quality-based approach is important in the mid-cap space. “Only a limited set of mid-cap stocks manage to grow and move into the large-cap universe. Some even slip into the small-cap category. That is why investing in a portfolio of stocks based on quality parameters is crucial,” says Anil Ghelani, head of passive investments at DSP Investment Managers.

Positive back-tested data

Back tested data shows that the index has the potential to outperform. Five-year return rolled daily from the start of April 2005 till the end of October 2021 was calculated and then the median for these return figures derived. While the Nifty Midcap 150 TRI Index yielded 14.6 per cent, actively-managed funds had an average return of 15.8 per cent. The Nifty Midcap 150 Quality 50 TRI gave a return of 19.2 per cent. In other words, the quality strategy outperformed both the broader mid-cap index and active funds.

The strategy also shows the promise of providing downside protection. 

If one looks at one-year return rolled daily over the same period, the sharpest minimum return came from the Nifty Midcap 150 TRI at -67.2 per cent. Actively managed funds gave an average return of -62.6 per cent while the Nifty Midcap 150 Quality 50 TRI fared better at -52.7 per cent (Sources: NSE, MFIE, DSPIM).

An index-based strategy also offers the advantage of low cost. DSP’s fund will have an expense ratio of 30 basis points (bps). Active mid-cap funds (direct) have a higher average expense ratio of 94 bps.

The rule-based approach to stock selection removes the scope for fund manager biases affecting performance.

This is also a well-diversified index. Exposure to a single sector doesn’t exceed 20 per cent, while exposure to a single stock can’t exceed 5 per cent of the portfolio or five times the weighting of the stock in the Nifty Midcap 150 TRI index.

What to watch out for

The index doesn’t include any valuation parameter.

“During bull runs, a lot of future earnings get factored into the stock prices of fundamentally strong companies, affecting near-term performance,” says Arnav Pandya, founder, Moneyeduschool. Investors will have to pay heed to valuation while investing or adopt a staggered approach.

Also, all we have at present is back-tested data. “Performance could be different in live market conditions. Alpha tends to shrink as more money starts chasing the same set of stocks,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor.

Should you invest?

Financial advisors believe that quality is a sound strategy. “The quality approach should help reduce risk. Investors who want mid-cap exposure with lower risk may opt for this theme,” says Pandya.

However, take exposure gradually. “If you have an allocation of 20 per cent to mid-cap funds, allocate 5 per cent to this strategy. Build this exposure over time. As you gain conviction, you could raise allocation,” says Raghaw. As with any mid-cap strategy, invest with at least a seven-year horizon to tide over volatility. Finally, be prepared for bouts of underperformance as no strategy does well at all times.