UTI Nifty Midcap 150 Quality 50 Index Fund is a new offering from UTI tracking the Nifty Midcap 150 Quality 50 Index. DSP has an ETF based on this index launched about three months ago with an AUM of 36 Crores. Now that an index fund option is available, should investors consider this? A discussion.
A factor-based index is one in which parameters like volatility, momentum, alpha, ROE, PB, PE etc are used to construct the index instead of market capitalization. This is one way to reduce concentration risk in traditional indices like the Nifty and Sensex. This combines active rule-based stock selections with passive investing and is also known as a tilt-weighted index (that is biased to a type of strategy).
While the NIfty 100 consists of the top 100 companies based on full market capitalisation from NIFTY 500, the Nifty Midcap 150 Index represents the next 150 companies (companies ranked 101-250) based on full market capitalisation from NIFTY 500.
Construction of the NIFTY Midcap150 Quality 50 Index
The Nifty Midcap 150 Quality 50 Index has 50 stocks with higher profitability, lower leverage and more stable earnings from the Nifty Midcap 150 universe.
According to the methodology document, equal weight is given to return on equity (last fiscal year), debt to equity (last fiscal year) and last five year EPS growth variability. The debt to equity factor is not used for financial services stocks.
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For Non-Financial Service sector company:
Weighted Z score= 0.33 * Z score of ROE + 0.33 * – (Z score of D/E) + 0.33* – (Z score
of EPS growth variability)
For financial services sector:
Weighted Z score= 0.5 * Z score of ROE + 0.5*-(Z score of EPS growth variability)
Here Z scores refer to how much a particular factor deviates from the average value divided by the standard deviation.
The index is weighted by the square root of the free float market cap times the quality score. Each stock can either have a maximum exposure of 5% or five times its weight in the parent index.
It must be understood that this definition of “quality” is arbitrary.
Regular readers may be aware that we have pointed out twice (Nov 2019 and once in July 2020) that active midcap funds would struggle to beat the Nifty Midcap 150 Quality 50 (NMC150Q30) index: Midcap mutual funds struggle to beat this factor-based midcap index. In fact, we followed this up with another study that shows they have trouble beating the Nifty Midcap 150 index too! Myth Busted: Active mid cap mutual fund managers can easily beat the index.
So these are the natural questions we need to answer:
- Can we use UTI Nifty Midcap 150 Quality 50 Index Fund instead of active mid cap funds?
- Can we use UTI Nifty Midcap 150 Quality 50 Index Fund instead of Midcap 150 or Nifty Next 50 passive funds?
- Instead of buying this index fund, can I build a DIY portfolio of select midcap funds based on the index portfolio?
My fascination with factor-based investing has significantly waned thanks to this article: Data Mining in Index Construction: Why Investors need to be cautious. I have now come to appreciate that many of these factors are arbitrary in definition and designed for past outperformance which may or may not sustain in future.
As we saw yesterday – Should I exit Nifty Next 50 because of Paytm, Zomato and Nykaa? – index curators can happily change the security inclusion criteria at will.
These considerations apply to UTI Nifty Midcap 150 Quality 50 Index Fund as well. We can expect a TER of 0.4% to 0.5% for the direct plan similar to UTI S&P BSE Low Volatility Index Fund (link points to review; disclosure invested) and UTI Nifty200 Momentum 30 Index Fund (link points to review).
Unlike the definition for volatility, there is no universally accepted definition for a “quality stock”. Questions like why the above-mentioned balance sheet metric and not others were used can only be answered by the curator.
Their index construction is arbitrary, to say the least. They have a Nifty 200 Quality 30 and a Nifty Midcap 150 Quality 50. Why only 30 quality stocks from 200 stocks but 50 quality stocks from 150 stocks? Why only factor fund from the mid cap universe? Though it can never be proved, it reeks of backtesting bias.
So the investor interested in this NFO must be aware that the good past performance of NMC150Q30 shown below may or may not sustain in future. The fund expense ratio and tracking error play a role in defining returns and this cannot be backtested.
NMC150Q30 was launched only in Oct 2019. So much of the history (up to April 2005) is backtested and does not reflect index movement with real-time trading and constituent changes.
Performance of Nifty Midcap 150 Quality 30 Total Returns Index
Over the last 10 years, if we consider the 5-year return of the index on any given day, sometimes it has outperformed Nifty Next 50 and Nifty Midcap 150 and sometimes it’s been on par.
The 10-year rolling returns data is better, but notice the time period in the horizontal axis, it is only in the last five years. That is, the history is too short for us to assume that NMC150Q30 will always outperform the other two indices (No, the chart cannot be used as a probability!).
In both cases, the range of possible returns for NMC150Q30 is lower meaning lower risk as measured by volatility. This can be seen in the 5-year rolling standard deviation graph.
NMC150Q30 has lower volatility than its parent index or Nifty Next 50 and is comparable to that of the Nifty 100 Low Volatility 20 index. This is possibly an indication that “quality mid cap stocks” are relatively more stable”.
Now we shall compare the factor indices (UTI has three of these now).
In terms of 5Y risk spreads the momentum index is the highest. Next comes NMC150Q30 and then the low volatility indices.
The 10-year rolling returns data tells us no strategy will work at all times! The NMC150Q30 returns dropped dramatically in early 2018 when the midcap segment started falling. Momentum has only outperformed NMC150Q30 in the last couple of years.
Now let us try and answer some questions. We would like to reiterate that readers appreciate the risks of choosing factor-based funds before reading the following!
Is UTI Nifty Midcap 150 Quality 50 Index Fund a better choice than UTI S&P BSE Low Volatility Index Fund? (this index is similar in risk/reward to the Nifty 100 Low Volatility 30 index as shown before)
No. That would be a bit of an apple vs orange comparison as low volatility indices have a large cap tilt (notice 50 low volatility stocks from Nifty 300 are as rewarding as 30 low volatility stocks from Nifty 100). It makes no sense to ask if I can replace a large cap index with a mid cap one.
So then can I hold both? Yes, but only if you appreciate the limitations of factor indices mentioned above.
Please note: there is no skin in the game for me here. I will not be investing in UTI Nifty Midcap 150 Quality 50 Index Fund for the simple reason it is not required for my circumstances. So please ensure due diligence before investing.
If I have to choose between quality and low volatility, I would choose low volatility because it is a simpler product. The definition of volatility is well established and universal while the definition of quality is arbitrary. While metrics can be easily added or subtracted to the quality score, it is not easy (at least as far as my thinking takes me) to do this to low volatility without changing the nature of the fund.
Is UTI Nifty Midcap 150 Quality 50 Index Fund a better choice than UTI Nifty 200 Momentum 30 Index Fund?
Again a bit of an apple vs orange comparison (mid cap vs large and mid cap). However, considering that the momentum strategy does not pay as often as it should for the higher risk taken (see 10Y returns), if I have to choose only between these two, I would pick UTI Nifty Midcap 150 Quality 50 Index Fund.
Can we use UTI Nifty Midcap 150 Quality 50 Index Fund instead of active mid cap funds?
In addition to the more comprehensive evidence presented above, consider the following. From Feb 1st 2018 to Feb 3rd 2020 (a month before the crash), the mid cap segment kept moving down only 8 out of 21 actively managed mid cap funds were able to beat NMC150Q30. From 23rd March 2020 (market crash bottom) to 23rd March 2022, 18 out of the 24 actively managed mid cap funds were able to beat NMC150Q30.
More importantly, the winners in the first 2Y period are the same as that in the second 2Y period. For example, Mid Cap funds from Axis (the darling of investors before the crash), DSP and Taurus were winners in the first 2Y period but ended up on the losing side in the second 2Y period.
Mid cap funds from Motilal Oswal, Invesco and Tata were comfortable winners in the first 2Y period but just about managed to get into the winning side in the second 2Y period. So there is no guarantee of consistent performance from an active mid cap fund.
If most actively managed mid cap funds cannot beat a ruled-based midcap index during a market downturn, I would rather take my chances with UTI Nifty Midcap 150 Quality 50 Index Fund if I understand the limitations of factor investing and my goal is to beat the Nifty Midcap 150 index after expenses.
Can we use UTI Nifty Midcap 150 Quality 50 Index Fund instead of Midcap 150 or Nifty Next 50 passive funds?
Although there is not enough data-based support and I could well be wrong, I am inclined to say yes for those who don’t mind taking a chance.
We all know how frustrating it is to hold Nifty Next 50. How bad can the mid cap quality 50 fund be compared to that?! Also, Nifty Next 50 funds are only a little less expensive than UTI factor funds (assuming this will also cost about 0.4-0.5%). Again the above-mentioned caveats apply.
Please note: The above is a specific answer to a specific reader question. This does not mean we recommend everyone to stop investing in Nifty Next 50 and shift elsewhere!
Now wrt Nifty Midcap 150 index funds, we have already shown that the tracking errors are large – Not all index funds are the same! Beyond top 100 stocks tracking errors are huge! Even if we expect UTI Nifty Midcap 150 Quality 50 Index Fund to be that bad, the potential lower volatility and higher return is a chance worth taking. Again caveats apply!
Instead of buying this index fund, can I build a DIY portfolio of select midcap funds based on the index portfolio?
This cannot be analyzed or backtested in any way. This route is only suitable for those already investing in stocks and fascinated by mid cap stocks. We do not recommend this for new investors.
All said and done, readers must appreciate that UTI Nifty Midcap 150 Quality 50 Index Fund is a new fund. While the above recommendations may apply to established investors who do not mind investing in an unknown fund, newer investors may wait and watch the tracking error for a few months before deciding.
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