In recent years, there are has been considerable retail investor interest around mid and small caps – both stocks and funds. These funds – passive and active – are suitable for very long-term investors with a 10-year horizon and a robust risk appetite.

But what if there is a variant introduced to the combined mid and small cap index by including a couple of smart-beta factors into it?

Mirae Asset has rolled out a new Nifty Mid Small Cap 400 Momentum Quality 100 ETF (exchange traded fund) that is open for subscription till May 17. It is the first passive fund based on the above-mentioned factor-based index. For those without demat accounts, there would be fund of fund rolled out on the same underlying index and it would be open from May 10 to May 24.

Read on for more on how the smart-beta index works, risks involved and to take an informed call on whether you should be investing in the new fund offer.

What’s the fund about?

Smart-beta investing is considered to be a sound blend of active and passive strategies. Passive because there are underlying indices that track these factors. It is also active because filters are used to short-list stocks into the index, which is then reviewed periodically. Every factor - quality, momentum, low volatility, value or dividend yield - has a period when it works, though timing of entry and exit is not easy.

Momentum factor’s underlying assumption is that stocks that are continuously rallying will continue to do so for the foreseeable future. Quality is a smart-beta factor focuses on companies with large profit margins, high return ratios, low leverage and stable cashflows.

The parent Nifty Mid Small Cap index has 400 stocks – 150 from the midcap universe and 250 from the small cap segment. In the Nifty Mid Small Cap 400 Momentum Quality 100 index there would be 50 stocks each from the mid and small cap segments.

From the parent index, stock exclusion, selection and weightage criteria are set to arrive at the factor index.

The exclusion criteria are listing history, circuit filter breaker, pledged promoter holdings, average low daily trading value and low turnover ratio.

Then the stock selection criteria are applied to this universe. The quality factor has return on equity, debt to equity, and earnings per share variability as criteria.

For the momentum factor, 6-month returns and risk, and 12-month returns and risk are applied as criteria.

Equal weightage is given for momentum and quality factors. A final set of stocks with suitable weightage (capped at 5 per cent per share) based on a composite z-score and free float marker capitalization of companies.

The index constituents are reviewed once in six months.

What should investors do?

As indicated earlier, the combination of mid and small cap indices means that the index investment is suitable only for those with high penchant for taking risk.

Given that a couple of factors are added to the mix for further filtering and a smart-beta portfolio, there would be multiple aspects to keep track of.

Based on back-tested data, the Nifty MidSmallcap400 Momentum Quality 100 TRI index has outperformed the Nifty Midcap 150 and Nifty Mid Small Cap 400 indices across one-, three- and five-year timeframes. It has also done better than the Nifty Small Cap 250 index over a five-year timeframe. In relation to the risks involved, the returns are reasonable.

Mirae Asset has a fairly robust track record as a fund house managing equity schemes. This ETF is the first passive fund tracking the factor index.

Investors who can stomach volatility and also wait it out for two smart-beta factors to play out to make gains in their portfolio can consider the fund. Even so, investors must consider it for the satellite part of their portfolio and deploy only very small sums or take the SIP (systematic investment plan) route for taking exposure to the fund.

Others can wait for the fund to develop a track record before considering it.

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