Why Nifty Midcap150 Quality 50 index performance is a warning for factor investing fans

Last Updated on November 2, 2023 at 8:40 amA few years ago, when the NSE introduced factor indices, aka smart-beta investing, I was among the first to get excited and wrote a slew of articles such as these: (1) Are Nifty Smart Beta (strategic) Indices better than the Nifty Next 50? (2) Picking Stocks With Low Volatility: A simple but effective strategy? (3) Nifty High Beta 50: an unsmart beta strategyFactor investing combines the benefits of active stock picking based on a pre-defined definition and passive investing. A factor-based passive fund is more expensive than a market capitalization-based passive fund but less expensive than a traditional active fund. Index curators push factor indices as a”market-beating” option on an absolute or risk-adjusted basis, as it aids their revenue if more AMCs launch products that track such indices.My enthusiasm was short-lived when an industry expert I admire pointed out that the definitions and stock baskets are cherry-picked to produce good results with past data. This does not mean they will work in future. He summarised his thoughts here: Data Mining in Index Construction: Why Investors need to be cautious.He later pointed out something that I did not realise: There is a significant phase lag between ideas that turn into products in the “West” and in India. When the Indian MF industry and the Indian investor turned their attention to factor indices, the West had already started recognising that these funds would not always outperform. See, for example, Factor ETFs Fail to Deliver Their Promised Outsize Returns. More and much older articles can be found searching for “factor investing failure”.Soon after the Nifty Midcap150 Quality 50 index was launched, I analyzed its performance and found Midcap mutual funds struggle to beat it. Soon, the index was added as a benchmark to our monthly equity mutual fund outperformance screener.Thanks to his counsel (he does not wish to be named), I was significantly mellowed in my appraisal of the UTI Nifty Midcap 150 Quality 50 Index Fund and DSP Nifty Midcap 150 Quality 50 Index Fund. The crux of the argument is that the definition of “quality” (and “value”) is quite arbitrary.I continue to believe in “low volatility”. I am invested in UTI S&P SE Low Volatility Index Fund and use the notion for my occasional stock picking: Stock Portfolio Analysis: Oct 2023 (which, by the way, is not doing so well in the last few months, but my intention with it is to serve as an income source so I am not too worried). Our anti-factor expert does not think much about low volatility either. 🙂 Guess I will live and learn some lessons here!This is the performance of Nifty Midcap150 Quality 50 vs Nifty Midcap150 since inception.Performance of Nifty Midcap150 Quality 50 vs Nifty Midcap150 Total Return Indices from Apr 2005If you casually look at this, this seems like a “wow” graph advertising the efficacy of the quality factor. A closer look would tell you that the factor index has had at least two drawdowns (fall from a peak) higher than the base mid cap index – during the 2020 crash and the fall since Oct 2021. Still (some would argue), “quality” has outperformed. Not so fast.This is the performance over the last 12 years. To the left of the arrow is a 10-year window where the factor index has done well. To the right of the arrow is the last two-year window.Performance of Nifty Midcap150 Quality 50 vs Nifty Midcap150 Total Return Indices from Nov 2011The ten-year outperformance from Oct 2011 to Oct 2021 has been erased by poor performance over the last two years. And how bad have the last two years been?!Performance of Nifty Midcap150 Quality 50 vs Nifty Midcap150 Total Return Indices from Oct 2021As someone commented on social media, “Looks like someone fell asleep at the wheel”! The quality factor fell more than the broad market mid cap index and did not recover as much over the six months, as shown below.Performance of Nifty Midcap150 Quality 50 vs Nifty Midcap150 Total Return Indices from March 28 2023I am unaware of the reasons behind this poor performance, and I am not interested in finding out as we would only end up with opinions. Also, this does not mean the quality index will always underperform in future.These results mean only one thing: Factor indices can underperform for significant periods and erase past gains. If you consider higher fees compared to broad-market passive funds, the underperformance will be higher.Those who “believe” in factor indices must be ready to go through such rough patches. Most investors are not capable of this. Therefore, we recommend sticking to a simple Nifty or Sensex index fund. Do share this article with your friends using the buttons below. 🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users! Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1,000 investors and advisors use this! 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