An introduction to investing in rule-based funds
PremiumIn rules-based funds, stock selection is done based on pre-determined rules
Mutual fund investing is generally about picking an expert to do the stock selection for you. With thousands of mutual funds out there, it’s tough to pick, monitor and rebalance stocks daily. It is easier to do this with help from experts. For investors who are unsure of selecting the right mutual funds, simple passive funds like Nifty 50, Sensex, S&P500 does an equally good job.
Although most investors see passive funds as a Nifty or Sensex based fund in reality, there are hundreds of indexes available in the market to invest in. There are mid-cap, small-cap, multi-cap, commodities, international and debt-based index funds and exchange traded funds (ETFs). Although new to investors, these categories have drawn good interest from investors over the last few years.
There is, however, a new category that is expected to make way in the next few years. They are called rules-based funds. What are they?
Rules-based funds are funds where stock selection happens based on pre-determined rules. There is no human intervention and hence no bias in how the stocks are selected. The rules are the holy grail, and the performance of the funds are purely dependent on those set of rules.
For example, someone who wants to filter out all companies with a profit margin of 40% or more can easily do that across 500 Nifty companies. The result would be, say 25 companies which can be then invested in. This is a very simple rule. In reality, there are many rules put in place for stock selection to happen.
These rules-based funds are a huge success outside India. For example, in the US, these funds are expected to be $3.4 trillion by the end of 2022 (which, for comparison, is more than India’s gross domestic product of $3.1 trillion).
For investors, there are two main types of rules-based funds: Quant funds and the others are called Factor funds. The difference between them is transparency.
Quant funds are governed by rules - but the rules are a secret sauce and hence are mostly kept secret. Giving up the rules would mean that the strategy can easily be replicated and hence the owner of the strategy would not be able to sell it effectively.
The other types of rules-based funds are factor funds. These funds are 100% transparent and therefore, investors looking for transparency can opt for these funds. Factor funds fall in between active and passive funds.
Unlike Nifty 50 or Sensex index funds, where the objective is to track the benchmark’s performance, factor funds are built to outperform a broad benchmark such as a Nifty 500, or a Nifty mid-cap 150.
The most popular factors globally are based on styles such as momentum, value, low volatility and quality. A momentum factor fund selects stocks that have the highest momentum (i.e. price appreciation).
A value fund selects stocks that have the most attractive valuations (measured by price/earnings or price /book value).
Low volatility funds provide access to stable stocks and Quality funds select stocks based on long-term profitability among other things.
Factors thus provide investors with a transparent rules-based stock selection process at a low cost. Do Factors fair better than index funds?
In the current investment climate, Factors are being sold as funds that outperform the benchmark but in reality, this is not always the case. Like all managed funds, there are moments when Factors outperform the index and times when they don’t.
However, over the long run, factor funds have outperformed the index in the last 10-15 years especially momentum, low volatility and quality. Investors buying into the strategy should expect these strategies to underperform periodically, hence are advised to stay in for the long-term.
In conclusion, investors looking to build a portfolio that has the potential to beat broad benchmarks (at transparency and low cost) should look at rules-based investing. However, investors should keep expectations in check and remember that these strategies will have periods of poor performance too (just like any other managed funds).
Pratik Oswal is head (passive funds), Motilal Oswal AMC, and chief executive officer of Glide Invest.
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