DSP Nifty Smallcap250 Quality 50 Index Fund Review

DSP Nifty Smallcap250 Quality 50 Index Fund is an open-ended fund tracking the small quality index in its name. The fund is currently in its NFO period. This article reviews the index’s performance and discusses if investing in this new passive fund makes sense.

According to the NSE, “the Nifty Smallcap250 Quality 50 Index tracks the performance of small cap stocks selected based on their quality scores. The quality score for each company is determined based on return on equity (ROE), financial leverage (Debt/Equity Ratio) and earning (EPS) growth variability analysed during the previous 5 years. The index includes up to 50 stocks selected from the parent Nifty Smallcap 250 index based on the high-quality score.  The weight of the stock in the index is derived by multiplying the square root of the free float market cap with the quality score of
that stock”.

Regular readers may be aware that we have repeatedly cautioned about the arbitrary nature of the “quality” factor and the problem of Data Mining in Index Construction( Why Investors need to be cautious).

Also see:

• Why Nifty Midcap150 Quality 50 index performance is a warning for factor investing fans
• DSP Nifty Midcap 150 Quality 50 Index Fund Review
• UTI Nifty Midcap 150 Quality 50 Index Fund Review

Therefore, investors should not take any pitch that goes, “This fund invests in quality small cap stocks” seriously.

Readers may also know about our stance against all small cap funds: Is there any proof small cap mutual funds would outperform in the long term? Also, Why are you not recommending mid cap and small cap funds?

All charts shown in the article can be made with the toolset part of the freefincal investor circle. Also, see A simple plotting tool to compare MFs, Indices, Stocks, Gold, etc.

If we look at rolling return graphs such as these, things look hunky-dory. Much of the factor index investing history is simulated, and once there is a fund tracking it, things may change as it happened with the Midcap quality index (see graphs in the first link above). And the history available is too short. Notice the x-axis window is only about 10-years. So, our notions of return (and risk) have poor foundations.

The recent drop in the midcap quality index can also be seen above. It can also happen with the DSP Nifty Smallcap250 Quality 50 Index Fund.  The rolling volatility (measured using the standard deviation) is below.

If we look at the since-inception performance, it looks glorious. This is because we are distracted by the performance on the right.

A closer inspection shows that the quality index underperformed from April 2005 to February 2011. This encompasses a bull run, a crash and a recovery.

Can you be sure such a bad run will not occur again? Also, we must remember that a Nifty Smallcap250 Quality 50 Index Fund would be much more expensive than a Nifty Smallcap250 Index Fund, which will hurt more during a poor run.

That said, there are two positives (with hefty caveats):

1. DSP Nifty Smallcap250 Quality 50 Index Fund will only invest in 50 stocks compared to a small cap 250 index fund. So tracking errors are expected to be lower (but offset by the higher expense ratio for the “quality” factor).
2. DSP Nifty Smallcap250 Quality 50 Index Fund can be considered as a low cost alternative to an actively managed small cap fund (performance analysis will be published in a forthcoming article).

However in both cases, it must be clearly understood that “quality” does not mean consistent outperformance. DSP Nifty Smallcap250 Quality 50 Index Fund could underperform a small cap 250 index fund or active small cap funds from time to time and for long periods.

We reiterate that a small cap fund of any kind is not necessary for a portfolio. A flexicap fund offers all the exposure to small cap stocks one needs. This new fund offer comes with new, unknow risks and may be used as indicated above by those insistent on small cap exposure. Others can avoid it.