Introduction

Index investing is popular for its simplicity, low costs, and time efficiency. However, it has two major limitations: your returns are capped by the market's performance, and your portfolio's value will decline in line with market downturns. So, can you enhance returns while mitigating risk? The answer lies in factor investing. This article explores various factor indices and identifies those with superior performance. But first, let’s delve into the concept of factor investing.

What is Factor Investing?

Factor investing involves selecting investments based on specific criteria that influence portfolio performance. Some well-known factors include:

1. Quality: Targets investments based on specific quality metrics.

2. Value: Focuses on undervalued securities.

3. Size: Prefers smaller companies.

4. Momentum: Looks for stocks with recent strong performance.

5. Low Volatility: Seeks stocks with lower price fluctuations.

    

A common application of these factors is smart beta, where indices are constructed using one or more factors, blending active and passive investing.

Examples of Factor Indices

Consider the Nifty 50, which tracks the largest and most liquid Indian companies. When certain value criteria are applied to the Nifty 50, we get the Nifty 50 Value 20 index, consisting of 20 value stocks from the Nifty 50. These modified indices aim to outperform their parent indices in terms of returns, diversification, or volatility. But do they always succeed? Let’s examine.

Evaluating Factor Indices

The National Stock Exchange (NSE) lists 35 factor indices, but not all are investable due to issues like low trading volumes or insufficient data. Here are some investable indices with good trading volumes and performance histories:

1. Nifty Alpha 50

2. Nifty Alpha Low Volatility 30

3. Nifty50 Value 20

4. Nifty100 Low Volatility 30

5. Nifty100 Quality 30

6. Nifty100 Equal Weight

7. Nifty50 Equal Weight

Performance comparison of factor indices

Let’s first look at their returns. The table below shows the 5-year rolling return of these indices and their benchmarks.

Returns

For the Nifty Alpha 50 and Nifty Alpha Low Volatility 30 indices, there isn't a clear parent or benchmark. However, since both indices include large and mid-cap stocks, the Nifty LargeMidcap 250 index is used for comparison.

Out of the seven factor indices, four have outperformed their parent indices: Nifty Alpha 50, Nifty Alpha Low Volatility 30, Nifty 50 Value 20, and Nifty 100 Low Volatility 30. The remaining three indices, Nifty100 Quality 30, Nifty100 Equal Weight, and Nifty50 Equal Weight, did not surpass their parent indices.

However, returns are only part of the story. We must also evaluate the volatility of these returns. To do this, we examine the standard deviation of the average 5-year rolling returns. A higher standard deviation indicates greater volatility.

Volatility

Only the Nifty100 Low Volatility 30 index outperformed its parent index in terms of both returns and volatility. The other factor indices exhibited higher volatility compared to their parent indices. Given its superior return profile and lower volatility, the Nifty100 Low Volatility 30 is the preferable option.

To gain a more comprehensive understanding, we should look at risk-adjusted returns. This is calculated by dividing the average rolling returns by their standard deviation, providing insight into whether the returns justify the risk or volatility involved. The table below highlights this risk-adjusted performance.

Risk Adjusted Returns

Selecting the Best Factor Index

Four indices stand out for their performance: Nifty100 Low Volatility 30, Nifty Alpha Low Volatility 30, Nifty Alpha 50, and Nifty50 Value 20. Here’s a closer look at each:

Nifty100 Low Volatility 30: Derived from the Nifty 100, this index selects 30 less-volatile large-cap stocks. It offers superior returns with lower volatility, making it an excellent choice for large-cap exposure.

Nifty Alpha Low Volatility 30: A multi-factor index combining alpha and low volatility, it includes stocks from the Nifty 100 and Nifty Midcap 50. It offers higher returns with acceptable volatility, suitable for investors seeking large and mid-cap exposure.

Nifty Alpha 50: This index picks 50 stocks from the top 300 by market cap based on alpha. It has high returns but also higher volatility, ideal for adventurous investors looking for both large and mid-cap exposure.

Nifty50 Value 20: Selecting 20 value stocks from the Nifty 50, this index uses metrics like P/E ratio and ROCE. It provides higher returns with manageable risk, perfect for those interested in value investing.

Conclusion

Factor investing can provide better returns and risk management compared to traditional index investing. By choosing the right factor index, investors can tailor their portfolios to achieve higher returns while managing volatility. The Nifty100 Low Volatility 30, Nifty Alpha Low Volatility 30, Nifty Alpha 50, and Nifty50 Value 20 indices are excellent options, each catering to different investment preferences and risk tolerances.