Nifty 200 Quality 30 ETF: Well-suited for investing in companies with superior financial metrics

Investors are constantly looking to find the right winning mix in the markets. Over the years, there have been multiple factors that have been used to group stocks and explain their behaviour.

Macro factors such as inflation, economic growth, interest rates, liquidity, emerging economic powerhouses and so on are one such set of factors. The second set comprises style factors used by fund managers. Some common factors are momentum, low volatility, quality, value, growth and dividend yield. Using these style factors for stock selection is commonly referred to as smart-beta investing. Essentially, smart-beta investing combines the best of active and passive modes to generate superior returns than standard plain vanilla indices.

Each of these style factors have dedicated indices based on filters set with specific criteria. And there are exchange traded funds (ETFs) tracking these factor indices as well. Since these are low-cost products which are rule-based and without any fund manager bias, there is potential for outperformance.

In this regard, the Nifty 200 Quality 30 ETF may be a robust addition to an investor’s portfolio given its focus on companies with healthy earnings, return ratios and low leverage.

Understanding Quality Index

Companies classified as quality firms tend to have lasting business models and have considerable competitive advantages. Such quality firms tend to have low debt in their balance sheets, large cash positions and tend to have a superior earnings trajectory. They are characterized by low debt-equity ratio (minimal or no leverage), high return on equity (RoE), high return on assets (RoA), as well as superior margins. Such stocks usually command premium valuation over other firms in the market given their superior financial and return metrics.

The constituents of the Nifty 200 Quality 30 index are decided applying a filter on the Nifty 200 index. A list of the top 30 companies is shortlisted from the index based on a quality score.

The quality score for every firm is arrived at by incorporating financial parameters such as Return on Equity (ROE), financial leverage (Debt/Equity Ratio) and earning (EPS) growth variability over the previous five financial years. There is equal weightage given to all three parameters while arriving at the 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 capitalization and is capped at around 5%, making it a less concentrated and a well-diversified portfolio. Unlike regular indices where stocks are weighted based on free-float market capitalization, these indices have a limit on weightage.

Currently the index as 20 large-cap stocks and 10 mid-cap companies, giving a healthy blend of stability and growth for investors over the long term.

Index Performance

Over the past 10-year timeframe, the Nifty 200 Quality 30 index has actually edged past the Nifty 200 TRI and Nifty 50 TRI.

Also, in the last decade, the quality index has delivered higher returns than the Nifty 200 TRI and Nifty 50 TRI five times out of 10.
Another key factor to note is that the Nifty 200 Quality 30 Index has a dividend yield of 2.4%, compared to around 1.4% for the Nifty 200 TRI and Nifty 50 TRI. This stems from the superior earnings profile of the quality index.

Risk, as measured by standard deviation, is also lower in the case of the Nifty 200 Quality index compared to two other regular indices.

Taking the ETF route

With relatively lower risks, higher dividend yield and better returns over the long term, the quality index does make a case for investments. For the long term, the Nifty 200 Quality 30 Index can be a good portfolio diversifier. Investors can consider an allocation to this index after consulting their financial advisors to decide where the index fits in your overall portfolio.

Investors can consider investing into the ETF based on this index. Taking the ETF route would be ideal for investors as these are low cost and are traded actively on the exchanges, making it easy for investors to buy and sell units in real time. Demat account is required for this purpose. Investors can consider periodic investments in the ETF from a long term perspective.

Head Investment Strategy, ICICI Prudential AMC.