Can factor-based funds dethrone large-cap funds?

Is it time to say goodbye to large-cap funds ? Not long ago, they formed a staple part of investors' portfolios, providing decent returns in the long run and standing strong amid market swings. However, over the years, large-cap funds have struggled to beat the benchmark. This paved the way for index funds as a more attractive investment option and, more recently, factor-based funds.

Factor-based funds, what's that?

As the name suggests, 'factor-based funds' pick stocks based on certain 'factors' that have helped deliver superior returns in the past. Currently, only four factors are prominent for investment in India. They are:

• Momentum : Momentum funds invest in stocks with strong recent price performance. When stock prices are on an uptrend, momentum funds capitalise on them by investing in them.
  
• Value : These funds tend to identify and invest in companies with relatively low value and boast superior dividend yield and ROCE (return on capital employed) . Such funds are known to shine during bearish market phases as they are usually the first to recover since their underlying stocks were already priced conservatively.
  
• Quality : Funds focused on quality pick stocks with higher profitability, lower debt and stable earnings. In turbulent times, these funds offer safe sailing as quality stocks are more likely to weather the storm, thanks to their strong fundamentals.
  
• Low volatility : Low volatility funds invest in companies with fewer price swings, providing a smoother ride when markets are choppy.

Performance

We compared the returns of factor-based funds with the Nifty 50 index and the returns of an average large-cap fund over a five-year period. We chose these benchmarks because, despite these funds primarily investing in the top 200 companies (as per market cap), they allocate over 80 per cent of their portfolio to large caps.

We found that momentum and value-based funds have delivered impressively since their launch, outstripping the category average of large-cap funds and the Nifty 50 index 75 per cent and 88 per cent of the time, respectively. By contrast, funds based on quality and low volatility largely struggled, beating the benchmarks only 30 per cent and 45 per cent of the time, respectively.

Performance needs more than just one factor

Based on their past performance, it might be easy to conclude that momentum and value-based funds are worth investing in. However, no one single factor can sustain performance on its own.

Here's why. During bull markets and periods of sustained trends, momentum stocks typically outperform, owing to positive investor sentiment. Conversely, during bearish phases or economic downturns, value stocks often do better since they are already relatively undervalued and are less likely to see a fall. This blend of momentum and value ensures a balanced performance, smoothing returns throughout various market phases.

We used back-tested data from the Nifty 200 Momentum 30 and Nifty 50 Value 20 indices to test this. We compared the momentum-value combination (50-50 allocation to both) with Nifty 50 and the average large-cap fund using five-year-monthly rolling returns.

The results? The momentum-value combo outperformed the Nifty 50 index and large-cap funds a whopping 94 per cent of the time. Moreover, a glimpse at the 10-year SIP returns showed that the momentum-value combination outpaced the Nifty 50 index and large-cap funds by 4.8 per cent and 4.6 per cent, respectively.

Our take

We have seen that a combination of momentum and value-based factor funds has delivered impressive results. Hence, it's worth considering these funds as a substitute for large-cap funds.

But here's a word of caution: don't try to outsmart the market by timing these factor-based funds. Stick to them for the long term to build wealth.

Also read: Factor-based mutual funds: Fit or flop?