Factor ETFs: Why you should invest for long-term returns

While investing, everyone who adheres to a clearly defined rule-based strategy stands a chance to make money. If the rules have stood the test of time, the odds of winning are even higher. Factor-based or smart beta exchange traded funds (ETF) adopt this rule-based approach of portfolio construction. They can be an interesting portfolio candidate for smart investors.

Historically, portfolios constructed on the factors or parameters such as quality, value, growth, alpha, momentum, volatility, tend to reward investors with returns in excess of that generated by market-cap based indices. These factors can be expressed numerically and a factor index can be crafted. For example, the quality score of a company is computed using debt to equity ratio, return on equity and EPS growth variability in five years. Companies are then sorted on the quality score parameter in a rule-based manner and then a basket of them is created to offer an index comprising high-quality stocks.

Mutual fund houses tend to launch ETFs that track the performance of the factor indices. Factor indices thus are placed in a sweet spot between passively managed ETFs and actively managed equity funds. These schemes charge less than actively managed equity funds towards expenses. Hence, they are cost-effective. While an actively managed diversified equity fund typically charges between 1% and 2.25% towards expenses, the factor ETFs charge around 30 basis points. ETFs tracking popular market-cap based indices such as Nifty 50, charge as low as 5 basis points.

The factor ETFs not only score better on the costs, but they also can be rewarding. For example, in one year ended April 30, 2024, Nifty 200 TRI gave 36.09% returns, compared to 83.86% returns given by Nifty Alpha50 TRI and 70.03% returns given by Nifty200 Momentum 30 TRI. Over the same period Nifty Smallcap 250 TRI – the yardstick for popular small cap stocks, gave 69.67% returns.

Though the factor indices can do well over long periods, they may offer less returns compared to their market-cap based counterparts in various phases. For example, Nifty Smallcap250 Quality 30 TRI has given 61.21% returns over one year ended April 30, 2024. Also, compared to 26.03% returns given by Nifty 50 TRI, Nifty Growth Sector 15 TRI has given 22.78% returns.

Each factor goes through phases of underperformance. For example, in 2018-2020 value underperformed other factors. In 2018 and 2020 quality topped the performance chart. However, value came back with top of the chart performance in 2021-2023. Quality as a factor of investment, over 2021-2023, offered relatively less returns.In some cases, the fund houses also offer to mimic an index constructed after combining two or more factors. For example, Nifty alpha low volatility 30 index or Nifty MidSmallcap 400 Momentum Quality 100 index. While the former screens stocks on the alpha and low volatility factors, the later picks up mid-small cap stocks based on momentum and quality factors.Investors need to take a long-term view on these ETFs to materially benefit from them and should keep investing in them at regular intervals. Units of such ETFs can be held for a long term as a part of the core portfolio. Investors can also use these ETFs to complement their trading or investment style to achieve diversification. For example, an aggressive trader going after momentum trades, can park some money in the units of low volatility ETF. An investor keen on swing-trades in small cap stocks, may want to keep some money on ETFs tracking Nifty 50 Value 20 index. This index invests in the most attractively valued 20 stocks from the constituents of Nifty 50 index. Such an allocation leads to style diversification and it brings together uncorrelated or less correlated assets, which may improve risk adjusted returns.

Investors also get margin against the value of units of ETFs held in their demat account. This margin can be utilised for trading. Over a long period of time, regular investments in units of factor ETFs can help to create a wealth pool which can be utilised for funding various goals such as buying a house, vacations or even retirement.

(The author is the founder & CEO of SAS Online – a deep discount stock broking platform. Views are his own)