In some of the earlier posts, I have written about momentum and low volatility investing. In this post, I compare the performance of various factor-based indices.
What is Factor Investing?
This blog post from S&P gives an interesting analogy. Consider Factors as nutrients and food items as stock returns. Now, different food items (pulses, milk, bread, vegetables, meat, fish) will have different nutrients (carbohydrates, proteins, fat, vitamins, minerals etc) in varying proportions.
Rather than trying to find a wholesome food that provides you nutrients in the right proportion, you can pick up a combination of food items that gives you the desired level of nutrients.
Coming back to stocks, every stock’s/portfolio’s risk-reward characteristics can be explained through its exposure to various factors (value, momentum, quality, low volatility, alpha).
A factor-based index will bring together stocks that rank high on that factor. For instance, a Value factor index will consist of value stocks. From an investor’s point of view, such factor-based indices are an easy way to take exposure to different investment styles.
For instance, if you are keen to invest in a portfolio of value stocks, the Value index is a simple way to build such exposure. Or if you want a less volatile equity portfolio, you can consider investing in low volatility index or quality index.
I copy the information about various single-factor indices from NSE website. These factor-based indices are also called smart beta or strategy indices.
You can see that Momentum, Low Volatility and Alpha are stock price-action based factors. For instance, Nifty 100 Low Volatility 30 index picks up the least volatile stocks. And Volatility scores will depend on price performance of the stock over the last 1 year. The remaining factor-based indices (Quality and Value) are based on company fundamentals.
You must note that these indices are not mutually exclusive and can have common stocks i.e. these indices can have overlaps. You can find stocks that will find place in say Momentum, Alpha 50 and Low Volatility indices at the same time.
You must also note the launch dates of these indices. None of the indices (except Nifty Alpha 50) has more than 5-year performance history at present. Hence, you must see the performance of these indices in this light. Much of the performance data is back-tested and not live data. And you can expect back-tests to be good. After all, these indices have to be marketed.
Factor indices can’t be constructed in just one way (as NiftyIndices have done). S&P also maintains a list of factor-based indices. For instance, the methodology used by S&P to construct S&P BSE Momentum Index is different from the one used to construct Nifty 200 Momentum 30 Index. Even NiftyIndices has multiple variants of single factor indices for many factors. For instance, you have Nifty 50 Value 20 Index and Nifty 500 Value 50 index. Both take exposure to Value stocks.
Performance Comparison of Factor Based Indices
We compare the performance since April 1, 2005. Note that bulk of the data for these indices is back-tested. I will also refrain from singing praises of any single factor and will leave the analysis to your judgement.
The data is until October 1, 2020. Thus, we have 14 complete years and 2 incomplete years (2005 and 2020).
An interesting thing to note here is that the best performer over the last 15 years is the Nifty 200 Momentum 30 TRI. And it has NOT been the best performer in any of the 16 years. It has been the worst performer in 1 year. Consistency matters.
This also shows that, for excellent performance over the long term, you don’t have to be the best all the time. In this case, the Momentum index was not the best in any of the years. Note that the entire data for the Momentum index is back-tested. Hence, consider this success with a bucketful of salt.
On the other hand, the Nifty 500 Value 50 index topped the charts in 5 out of 16 years. Still, it is the worst performer. We saw something similar when we compared the performance of Low Volatility vs High Volatility stocks.
By the way, I am not saying value investing is bad. Or that Value investing doesn’t work in India. All this data shows is that Value stocks, as selected by NSE indices, have not done well over the last 15 years. In fact, if you look at the data closely, the Value index was the best performer for 5 years from the start of 2006 until the end of 2010. It is the past 10 years that value stocks have struggled.
This shows: When it comes to investing, nothing works all the time. I tried to show this between large, mid and small cap stocks in an earlier post. Factor indices represent different styles of investing and drive home this point much better. You can see that no single approach (factor) works all the time. Many of us tend to get attracted towards the investment style that has worked in the recent past. However, you can’t possibly switching to the best performing style just in time (and that too, all the time). Hence, if you are a long term investor, you must hedge your bets and diversify across different factors/investment styles.
Nifty Strategy (Smart Beta) indices: Rolling Returns
You can see that even with 3-year and 5-year rolling returns, the baton of the best performing strategy has kept on passing. You must not fall for the recency bias.
Nifty Factor Indices: Rolling Risk and Maximum Drawdowns
Low Volatility, Quality and Momentum have been the best performers. Value and Alpha come with the highest volatility.
Again, the sharpest drawdowns have happened with the Alpha and Value indices.
On the volatility and drawdown front, Momentum, Low Volatility and Quality indices have been clear winners.
Here is a risk-reward exhibit from S&P website. The data is slightly dated but I found this useful.
Even as per this figure, Low Volatility, Quality and Momentum have given the best risk-adjusted returns.
What should you do? How can you invest?
In my opinion, the factor indices can be part of your satellite portfolio. You can consider them as low-cost replacements for active funds in your satellite portfolio. Market cap-based indices can form part of the core equity portfolio.
Remember nothing works all the time. Thus, do not skew your portfolio too much towards a single factor.
Currently, there are no index funds for any of these factor indices. However, you have ETFs for some of these indices. Examples: ICICI Nifty Low Vol 30 ETF, Kotak NV 20, Edelweiss Nifty 100 Quality 30 ETF and a few more.
Do consider the cost (expense ratio) and compare the performance against the benchmark (tracking error). Since you have to buy an ETF, there will be transaction charges. And the problem of Price and NAV in the ETFs. And yes, the liquidity in the corresponding ETF.
Index funds or FoF (that invest in ETF around these indices) would have been an easier way to invest.
Remember, the mutual fund industry is dominated by AMCs that are powerhouse in actively managed funds. Active funds mean greater fund management charges too. Thus, expect reluctance of part of AMCs in launching index funds around these smart beta indices.
What about Multi-Factor indices?
Until now, we have focussed on single factor portfolios.
What if we combine features of two such factors into a single portfolio? I am talking about multi-factor indices.
A multi-factor index aims to tide over cyclicity of single factor and can perhaps result in more consistent performance. Higher returns. Or Lower risk. Or both. Or neither.
There are many ways in which you can combine these factors. You can mix up stocks that rank high on either of these factors. Or you can rank the stocks on both of these factors and take a combined rank to select stocks.
Extending the food analogy, let’s say Alpha index is masala dosa and Low Volatility index is paneer dosa. Then, Nifty Alpha Low Volatility 30 index is paneer masala dosa. A paneer masala dosa can have two slices each of paneer and masala dosa (you can do this on own). Or all the four slices could be the same, but the filling could be combination. As you can see below, the multi-factor indices work with the second approach.
I plan to cover multi-factor indices in subsequent posts.
Test Results of other Investment Strategies
Over the past few months, we have tested various investment strategies or ideas and compared the performance against the Buy-and-Hold Nifty 50 portfolio. In some of the previous posts, we have:
- Assessed whether adding an International Equity Fund and Gold to an Equity portfolio has improved returns and reduced volatility.
- Does Momentum Investing work in India?
- Does Low Volatility investing beat Nifty and Sensex?
- Nifty 200 Momentum 30 Index: Performance Review
- Considered the data for the past 20 years to see if the Price-Earnings (PE) multiple tells us anything about the prospective returns. It does, or at least has in the past.
- Tested a momentum strategy to shift between Nifty 50 and a liquid fund and compared the performance against a simple 50:50 annual rebalanced portfolio of Nifty index fund and liquid fund.
- Used a Simple Moving Average Based Market Entry and Exit Strategy and compared the performance against Buy-and-Hold Nifty 50 over the last two decades.
- Compared the performance of Nifty Next 50 against Nifty 50 over the last two decades.
- Compared the performance of Nifty 50 Equal Weight vs Nifty 50 vs Nifty 50 over the last 20 years.
- Nothing works all the time. Used Nifty 50, Nifty MidCap 150 and Nifty Small Cap 250 index to demonstrate that sometimes intuitive investment choices do not work.
- Compared the performance of 2 popular balanced funds against a simple combination of an index fund and a liquid fund.
- Compared the performance of a popular dynamic asset allocation fund (Balanced advantage fund) against an equity index fund and see if it has been able to provide reasonable returns at low volatility.
Additional Reads
Nifty 100 Low Volatility 30 Index
Methodology Document for Nifty Indices
S&P Dow Jones Indices: How do Single Factors perform in Different Market Regimes in India?