Assessing Tax impact while choosing investments

 

 

Factor Investing: An introduction

 

Factor investing, is an asset pricing and portfolio construction approach that involves targeting specific drivers of returns. There are five main factors associated with higher returns that are widely used in factor ETF strategies: value, small-caps, momentum, low volatility and quality (which is also known as dividend payers). A sixth factor, yield, is sometimes included in the main factor definition count.

For the purpose of our writeup today, we will be focussing exclusively on factor-based ETFs with some compelling statistics that should help you as an investor to:

- Critically evaluate performance of large cap investments in managed funds

- Usher in ETFs as a cost effective and promising part of your core portfolio

We will also restrict this analysis of funds to the large cap space. It is likely that in a few years midcap and small cap indexes will start outperforming their managed peers, but so far data points to a reasonably high Alpha in this space and making a choice of a good fund manager is all it takes.  However, today’s story is about large cap investments.

I have in the table below tabulated performance of all factor-based indexes

Scheme Name	Minimum	Maximum	Average	Std.Deviation	RPUR
Nifty Next 50 TRI	-15.6	76.5	18.0	15.1	1.2
Nifty 200 Momentum 30 Index TRI	-10.1	49.0	17.3	9.2	1.9
NIFTY Alpha Low Volatility 30 TRI	-5.6	40.8	17.0	8.4	2.0
Nifty 100 Low Volatility 30 TRI	-3.9	38.6	15.3	6.3	2.4
Nifty 50 Value 20 TRI	1.6	41.3	14.8	6.4	2.3
Nifty 100 TRI	-6.5	64.5	16.0	12.5	1.3
Nifty 50 TRI	-15.2	62.1	15.0	13.3	1.1

 

*Rolling returns from Jan1 2010 to Aug 30,2022

*RPUR is return per unit of risk

The names of the funds reflect the factors on which they are based. Factor investing is also called smart beta investing as weightages of the stocks are changed as per their factor based scores.

From the table above one can see how two of the factors seem to have driven the best return per unit of risk, the low volatility factor (a technical factor) and the Nifty Value 20.  The Low Volatility fund focuses on top 100 while NV20 creates its portfolio from Nifty’s 50. NV20 short lists companies from the Nifty 50 on the basis of four value parameters.1. Return on Equity 2. Price to book 3. Price to Earnings and 4. Dividend Yield. On the basis of their rating on above parameters stocks from the Nifty 50 are weighed and ranked and the best 20 make way into your portfolio.

It is fascinating as to how simple factor based ETFs can consistently outperform not only the indices against which they are benchmarked, but also managed large cap funds. The outperformance is not only in the returns department but also in the risk space. I pick NV20 ETF for comparison with managed funds. Let me show you the numbers

 

Name	Low	High	Average	St. Dev.	Sharpe
Mirae Asset Large Cap Fund (G)	2.80%	23.69%	15.14%	16.72%	0.48
SBI BlueChip Fund (G)	-0.65%	20.21%	11.71%	17.19%	0.25
Franklin India Bluechip Fund - (G)	-1.51%	17.61%	9.61%	18.27%	0.21
HDFC Top 100 Fund (G)	0.19%	18.15%	10.96%	17.28%	0.43
Nippon India Large Cap Fund (G)	-0.39%	19.07%	11.31%	18.43%	0.33
DSP Top 100 Equity Fund (G)	-1.37%	15.55%	9.35%	16.97%	0.36
Nippon India ETF Nifty 50 Value 20	5.42%	32.27%	20.48%	18.35%	0.36

·        Three year rolling returns from 11 July 2015 to September 5,2022

 

The difference in returns and risk parameters is stark. For more or less similar standard deviation the NV20 delivers far superior returns over three year rolling periods since inception. Also, there are no negative return three-year periods since its inception.

Managed funds typically charge anything between 1.5% to 2 % in management fee for regular plans. Compared to these ETF charge 0.10% to 0.3%. 

To an investor who doesn’t want to manage large cap portfolios, factor based ETFs are a good venue to start. Stock rebalancing happens automatically and at no cost to you. The fund management fees are also a fraction of that of managed funds. Because rebalancing is done by the funds, there is no tax outgo for the investor.

For HNIs who own large core portfolios in bluechips, dividends and capital gains are adding heavily to tax outgoes (not to mention putting additional tax burden via surcharges). For them, instead of buying 15-20 different stocks, a single portfolio via a factor fund  may make a lot more sense.

There are a few drawbacks however. The most glaring of them is liquidity and costs of transactions.  ETFS as they are today, don’t usually list at true price and there could be an enormous gap in actual NAV and traded price. Fund houses usually create units for large Investments, but for the smaller amounts do consider the funds that in turn invest in ETFs.  There is only a very slight difference in NAVs and really doesn’t impact returns for long term investors. For example, Nippon Nifty NV 20 Fund is a FOF that invests in Nippon NV 20 ETF.

For any queries feel free to throw in an email and I will be happy to guide you further.