Should investors opt for index funds?

Pratik Oswal: Basically, if you look at the category of index funds, there are many categories. You have your broad-based, large-cap, mid-cap, small-cap funds; you have your sector funds, such as IT funds and consumer funds. You also have international funds – S&P and NASDAQ – and you have debt funds which are popular.

In the area of ​​equities alone, you have broad-based funds, but also a category called factor funds, which falls under the category called rules-based investing. Based on predetermined rules, a stock selection process takes place in the underlying universe of stocks, say Nifty 500 or Nifty 200.

There are two types of rules-based funds – one is called quantitative funds, where the rule is not really known to the public. So basically it’s the secret sauce of the AMC and based on that the idea is to generate an index outperformance. The other is called factor funds where the rule is completely transparent. The investor knows the rule that governs this particular factor.

To give an example, value is subjective as a concept, but in a factor strategy, value is completely transparent. So in a value fund, you will always have stocks that have the lowest price-to-book earnings or price-to-book ratio. So it’s a factor called value. You have quality. You will have a list of stocks that have very low debt ratios and very high return on equity or return on capital employed. So these are certain rules that are standardized globally, and based on those rules, you have certain stocks that are selected in those funds.

Momentum is the fund we’re launching, which is one of those factors. Essentially, factors are the building blocks of the investment process.

To give another analogy, we can look at Warren Buffett. His investment process would be to buy undervalued companies, buy low volatility and very stable companies; it would only look at large caps, which again is a factor and it will look at high quality stocks. So these four are his investment processes, kind of building blocks, and each of them is actually a factor.

So, Momentum is one of those factors. What Momentum means is that the fund manager or the fund which is the Nifty 200 Momentum130 index fund that we’re launching, would buy the stocks that have the highest momentum over the last 6 to 12 months, and that would be part of of your wallet. What we have seen is that Momentum is a very specific driver of outperformance.

Ideally, factor funds sit between active and passive funds. So, the idea behind factor funds is that they are able to outperform the benchmark, but also, they are able to provide you at a very low cost, the cost of a broad based index fund. So you basically get the best of both worlds.

Momentum is one of those factors where the rule is that you would only buy stocks that are doing well in terms of price performance.

We are launching two funds but the index is the same. This is the Momentum Index and we basically offer two different formats. One is the ETF and the other is the index fund. What we have learned from history is that a lot of investors choose one over the other and we want to offer both formats because we know there are fans for ETFs and for index funds. Thus, our customers can choose between the format they prefer.

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