With equity markets ruling at all-time highs, it is a bittersweet time for new investors looking to invest in smallcaps. While they are excited about the tearaway returns clocked by smallcaps so far, there is a very valid worry that the ugly side of smallcaps may show up any time: in a downturn, small caps are generally first to fall and they fall fast. For such investors, DSP Mutual Fund’s launch of the first-ever ‘quality-focussed’ smallcap index fund may be an interesting development. Backtested data shows the quality index (Nifty Smallcap250 Quality 50) has outperformed in rallies and during falls compared to the broader index (Nifty Smallcap250), strengthening the former’s case for an investment. Then, should you invest during the NFO period which closes December 15? Here is a lowdown.

What is Nifty Smallcap250 Quality 50 Index

The Nifty Smallcap250 Quality 50 Index (launched in Mar-2023) tracks the performance of 50 small cap stocks which are selected based on their quality scores. Backtested data shows (see charts below) has outperformed in rallies and during falls compared to the broader index. This may be attributed to the quality index having companies have higher ROE and lower leverage compared to the normal index. The index is rebalanced semi-annually.

In Nifty Smallcap250 Quality 50, the quality score for each company is determined based on return on equity (ROE), financial leverage (Debt/Equity Ratio) and earning (EPS) growth variability analysed during the previous 5 years. The index includes up to 50 stocks selected from the parent Nifty Smallcap 250 index based on the high quality score. The weight of each stock in the index is based on the combination of stock’s quality score and its free float market capitalisation.

Major differences

It is important to understand where Nifty Smallcap250 Quality 50 and Nifty Smallcap250 differ.

1. Universe: Nifty Smallcap250 has a 515 stocks universe compared to 222 stocks for Nifty Smallcap250 Quality 50. The exclusion criteria such as circuit breakers, high pledged promoter holding, less liquid stocks, very high valuation, highly volatile and minimum 1 year listing history, and the inclusion criteria, such as RoE, Debt to Equity and Earnings Visibility, lead to a smaller stock set for the quality index.

2. Performance: Backtested data shows Nifty Smallcap 250 Quality 50 TRI (Total Return Index) has outperformed its parent index Nifty Smallcap 250 TRI since its inception. Also, Nifty Smallcap 250 Quality 50 TRI performed better than Nifty Smallcap 250 TRI in 12 out of 19 calendar years. Also, the quality index has outperformed on a rolling basis across periods indicating consistency compared to broader index and active funds.

3. Holdings: The quality index is a much more concentrated basket than the plain-vanilla index. For instance, the top-10 holdings of the quality index account for ~34% versus ~13% for the usual index. The top-10 in quality basket include CDSL, IEX, Sonata Software, Castrol, Birla Soft, JB Chemicals, KEI Industries, Sanofi India, NALCO and GNFC. In comparison, Nifty Smallcap250’s top holdings are Suzlon, BSE, IDFC, KEI, Cyient, RBL Bank, CDSL, Angel One, MCX and IIFL Finance. Sectorally, the Quality 50 index currently has no exposure to Media, Real estate and Energy sector. It is also Underweight Industrials, Financials and Consumer Discretionary while overweight in Materials, IT, Consumer Staples.

Our take

The existing Nifty Smallcap 250 index funds (direct plan) have a tracking error of 0.05-0.13%. Investors will have to monitor where DSP Nifty Smallcap 250 Quality 50 stands in this parameter. Additionally, the plain-vanilla index funds (direct plans) have an expense ratio of 14-41 basis points. Typically, factor-based index funds are a tad costlier.

If you agree with the methodology of the smallcap quality index, then you can consider DSP Nifty Smallcap 250 Quality 50 index fund as it promises to exhibit lower volatility, more stability and ultimately better returns than a typical Nifty Smallcap 250 index fund. SIPs will be the ideal way to invest and the suggested tenure is 10 years or more.

However, investors must note that management quality is particularly crucial in the context of small-cap stocks/funds. A quant-based index or index fund based on quality factor largely misses the management quality aspect of small-cap stocks. Strong corporate governance practices are extremely vital in case of small-cap stocks, especially in the Indian context where small-caps are extremely under-researched. If you are looking for promising actively-managed small-cap funds, consider top-rated offerings such as Nippon India Small Cap, Quant Small Cap and SBI Small Cap.