Weekly Musings – NFO Pick (Bandhan Nifty Alpha 50 Index Fund)

23 Oct 2023 , 10:47 AM

UNDERSTANDING FACTOR INVESTING

In the latest weekly coverage on mutual fund NFOs, we cover the Bandhan Nifty Alpha 50 Index Fund. As the name suggests, the Bandhan Nifty Alpha 50 Index Fund is a factor fund, that has been the big story in recent months. Of course, factor funds have not been around for very long to really be able to judge their performance, but most factor funds have given good returns, albeit with bouts of annual volatility. 

Factor funds actually fall somewhere between funds and passive funds. For instance, an active funds involves regular churn of portfolio by the fund manager, who identifies the stocks to buy and the stocks to sell, based on the recommendations of an Investment Committee. Passive investing is, as the name suggests, just pegging the portfolio to an underlying passive index and only worrying about the tracking error. Between the active funds and passive funds are the factor funds, which look to leverage on certain factors or rules, rather than fund manager selection, to delivery alpha.

WHAT INVESTORS MUST KNOW ABOUT FACTOR INVESTING

Here are some basic things that investors must understand about factor investing. 

1. A factor helps to explain or identify the unique features or characteristics that drive the returns on a stock. Some call it the X-factor, but this something beyond pure chance. These are actual identifiable factors that drive performance beyond a passive index.

    

2. The entire idea of factor investing is about identifying factors, beyond the overall market, that actually have an influence on stock returns. These are the factors that make a particular investment better or worse.

    

3. From an investor perspective, picking stocks with specific factors can help the investor to build a portfolio that generates higher risk-adjusted returns compared to a pure and passive index portfolio. It is alpha that factor funds target.

    

4. Till now market returns were classified into market returns and alpha (excess returns).  However, the alpha was not fully explained. Factor investing breaks up the alpha further into factor returns and fund manager performance. 

    

5. So, while the typical passive index fund only tries to capture the beta part of the returns or the market returns, the factor fund hopes to capture the market returns plus that portion of alpha that is generated by factors. That enhances returns in this case.

    

6. In short, the factor captures part of the alpha that is normally believed to be generated by the fund manager, but actually generated by factors. This additional returns are generated on the back of a small additional cost in the form of total expense ratio (TER).

One such Factor index on the NSE is the Nifty Alpha 50 Index, and this fund will be indexed to the specific factor index. Unlike the typical passive fund that has low churn and hence much lower costs, the factor funds have relatively higher costs due to the more aggressive churn involved.

How factors are identified and used by fund managers?

Clearly, the idea of factor investing looks quite enticing considering that it can generating higher returns compared to a pure passive funds due to the ability to identify specific factors that influence returns. Remember, these are ruled based factors and hence can be converted into an index and a factor fund can be pegged to such an index. Here are some popular factors that are used in stock markets.

Momentum Factor: As the name suggests, this factor is about recent momentum of the stock in the market or where the performance is being driven by momentum. The specific stocks would be the ones with strong recent performance.

Low Volatility Factor: This is a relative measure and identifies stocks that have lower than average market volatility. Here volatility can be either defined in terms of standard deviation or variance of returns

Quality Factor: The focus of this factor is on identifying stocks with better earnings and asset quality. Some of the proxies for quality factor are companies with low debt, stable earnings and other quantitative and qualitive metrics that can reasonably reflect quality.

Value Factor: Value factor is about the stock is priced vis-à-vis its intrinsic value. The focus here is to focus on stocks that are trading at substantial discounts to their fundamental value and hence leave sufficient margin of safety for the investor.

Size Factor: The focus is on identifying stocks with lower market cap since historically such stocks have proved to outperform the large caps and the indices in general. Small cap stocks are preferred and churned based on set rules.

The gist of the factor story is that these can be automated and rule-based and hence converted into an index. This makes factor indexing possible, which is what the Bandhan Nifty Alpha 50 Index Fund NFO is all about.

Quick word on the Nifty Alpha 50 Index

 To understand the Bandhan Nifty Alpha 50 Index Fund, it is essentially to first understand the constitution of the Nifty Alpha 50 Index and how it has performed vis-à-vis its other index counterparts. Here is a quick run-down.

• The Nifty Alpha 50 index is based on stocks that generate Jensen’s alpha on a rolling basis. Jensen’s Alpha is the excess returns over what the fund should have ideally earned considering the risk entailed in the fund. The Nifty Alpha 50 index systematically invests in stocks with improving alpha and cuts positions on stocks where alpha is diminishing. Churn is quite high in this index and stocks are tossed every 3 months.

   

• The Nifty Alpha 50 Index has some unique features. The stock must have a minimum listing period of 1 year to be eligible for inclusion. It must be among the top 300 stocks in terms of market cap and must be among the top 50 companies based on alpha measure. The exercise is repeated every 3 months and the weightage of the stock in the index is proportionate to the alpha of the stock.

   

• Effectively, how is this factor index; Nifty Alpha 50 index different? As we shall see later, historically, its performance has managed to do better than the broad-based indices. Also, it can be a good proxy for a market cap rotation or a sector rotation strategy. But, above all, it adds alpha to the Beta in a systematic and rule-based manner, something that is more reliable than a purely discretionary approach.

Key investment takeaways on Nifty Alpha 50 index

Here are some standout takeaways from Nifty Alpha 50 index as an investment basket. This is specifically relevant in the case of Bandhan Nifty Alpha 50 Index Fund, since it is a fund that is benchmarked to this particular factor index.

• If you look at the Nifty Alpha 50 index TRI (total returns index), it has generated 3 year rolling returns of 17.4% annualized as compared to an average range of between 12% to 14% for the other generic indices in the market. However, it must be noted here that the higher average returns come at the cost of higher volatility. The same story repeats, even if you look at 5-year rolling returns.

   

• For example, the minimum returns on the other generic indices in a worse case scenario is only in single digits. However, in the case of the Nifty Alpha 50 index, the minimum returns are as low as -19.3%. This means that the average volatility of the Nifty Alpha 50 index is at 24.6% compare to the average range of volatility of other indices between 12% and 16%. Investors in this fund must be prepared for higher volatility risk. The same story repeats, even if you look at 5-year rolling returns. 

   

• The Nifty Alpha 50 index has generated strong alpha (excess returns) during bull markets. For instance, during the secular bull market between April 2005 and January 2008, the Nifty Alpha 50 index generated excess returns of 146%. Even in the post COVID rally in 2020, the Nifty Alpha 50 index generated excess returns of 44%. However, during the crash of 2008 and the fall of 2018-2020, the Nifty Alpha 50 index gave much lower returns than the generic Nifty index.

   

• Due to the constant churn in the Alpha factor, the Nifty Alpha factor sees continuous churn in terms of market cap and sector concentration. For example, in September 2022 and December 2022, the large cap exposure was above 40%, while in September 2023 it is down to 16.5%. During the same period, small cap exposure went up from 12% to 33%. This story applies to sectoral churn also. In the recent 4 quarters, the dominant sector in the Nifty Alpha 50 index with over 35% exposure is financial services. However, between March 2021 and March 2022, IT had dominated with a share of over 32%. 

   

• As of September 2023, the Nifty Alpha 50 Index had 41.2% exposure to financials and 31.6% to industrials. However, the portfolio is largely market-cap agnostic. The 5 big stock exposures were Karnataka Bank, Suzlon Energy, Finolex Cables, NCC Ltd and IRFC. This largely captures the stock with the maximum recent momentum. That strategy works perfectly in bullish markets and even in flat markets, but can backfire in bearish market conditions. 

Pros and cons for Bandhan Nifty Alpha 50 Index Fund NFO

Let us look at the positives of the fund first. In terms of returns, the Nifty Alpha 50 index has generated 10-year CAGR returns of 24.3% compared to 14.5% for the Nifty 50 index. However, this has come at a higher cost since volatility of the Nifty Alpha 50 index is 20.2% compared to 16.5% for the Nifty. However, if you look at in terms of neutralized risk-adjusted returns, the Nifty Alpha 50 index is still 25% better than the Nifty 50 index. This higher excess returns come from a focus on momentum and a more frequent churn of the portfolio in favour of the winners.

What are the downsides of the Bandhan Nifty Alpha 50 Index Fund? Firstly, we have already seen that volatility and downside risk is much higher in the Alpha index as compared to the Nifty 50 index. Secondly, this Alpha index adapts to market momentum dynamics, but with a lag. The actual impact of the length of the lag is not yet known. Thirdly, the Bandhan Nifty Alpha 50 Index Fund could deeply underperform if bearish conditions sustain in the market for a longer period. Finally, just like other factors are cyclical, alpha is also cyclical and that is a risk that the Bandhan Nifty Alpha 50 Index Fund runs.

Highlights of the Bandhan Nifty Alpha 50 Index Fund NFO

Here are some key takeaways that investors should know about the NFO.

• The NFO of Bandhan Nifty Alpha 50 Index Fund opens for subscription on October 25, 2023 and closes on November 06, 2023. Nemish Sheth will be the fund manager to the scheme.

   

• The index performance will be benchmarked to the Nifty Alpha 50 TRI index and will entail higher churn and higher TER as compared to a pure passive index fund.

   

• Entry loads are banned by SEBI, and this fund will not charge any exit load, irrespective of the timing of the exit. 

   

• Being a passive fund, the investment objective is to replicate the Nifty Alpha 50 index in terms of portfolio mix with focus on minimization of tracking error.

   

• Lumpsum purchases in the NFO must for a minimum of Rs1,000 while SIP investments can be in multiples of Rs100 for monthly SIP.

To sum up, the Bandhan Nifty Alpha 50 index fund is ideal for investors with a relatively higher risk appetite and looking to smart beta strategies in a passive portfolio.