Your Questions Answered: What are pros and cons of investing in Nifty MidSmallcap400 Momentum Quality 100 Index?

The Nifty MidSmallcap400 Momentum Quality 100 Index tracks stocks with momentum and quality traits, aiming for balanced returns. Momentum indices consider recent price movements for stock selection, based on the idea of continued performance.

Kuvera
First Published20 May 2024
The Nifty MidSmallcap400 Momentum Quality 100 Index focuses on mid and small-cap stocks with strong momentum and quality features.
The Nifty MidSmallcap400 Momentum Quality 100 Index focuses on mid and small-cap stocks with strong momentum and quality features.

Q. I am a young professional, working with a private company as a management trainee. I have been investing in large cap index funds for 2 years. I now wish to diversify my investment into other segments. My acquaintances have suggested the Nifty MidSmallcap400 Momentum Quality 100 Index, can you please explain the pros and cons of investing in the Nifty MidSmallcap400 Momentum Quality 100 Index? Further, can you also explain what momentum indices are? 

Pradeep Simha, Hyderabad, Telangana 

The Nifty MidSmallcap400 Momentum Quality 100 Index, is a strategic index that has been designed to track the performance of stocks that exhibit both momentum and quality characteristics. The Nifty MidSmallcap400 Momentum Quality 100 Index is a subset of the Nifty MidSmallcap 400 Index, which includes mid and small-cap stocks. 

The unique aspect of this index is its focus on companies that not only have strong momentum in terms of price performance but also display high-quality attributes. This combination aims to provide a balanced approach to stock selection, potentially leading to better risk-adjusted returns for investors.

Momentum is measured by the 6-month and 12-month price returns of stocks, adjusted for volatility. This ensures that the index captures the performance of stocks that have shown a consistent upward trajectory in their prices. On the other hand, quality is assessed through a company's return on equity (ROE), financial leverage (debt-to-equity ratio), and earnings growth variability over the past five years. These factors are indicative of a company's operational efficiency, financial stability, and growth prospects.

Also Read: Your Questions Answered: What is the difference between mutual funds tracking Nifty Bank Index and Nifty PSU Bank Index?

The index methodology involves a semi-annual reconstitution in June and December, where stocks are evaluated and selected based on their composite momentum-quality score and free-float market capitalization. This process ensures that the index remains up-to-date with the most promising mid and small-cap stocks in the market.

What are momentum indices? 

Momentum indices are essentially indices that take into account the price movement of the stocks, whilst determining the eligibility/selection of stocks, constituting the index. These indices operate on the principle of momentum investing, which is based on the idea that assets which have performed well in the recent past are likely to continue performing well in the short to medium term. 

Momentum investing is a strategy that aims to take advantage of the continuation of existing market trends. It involves buying securities that have had high returns in the near past and selling those with poor returns over the same period. The underlying assumption is that securities which are moving upwards in price will continue to rise, and those moving downwards will continue to fall.

Also Read: Mutual Funds: How do index funds provide long-term wealth creation opportunities?

Eligibility criterion 

  • The primary pool for selection comes from the Nifty MidSmallcap400 index, which encompasses a broad spectrum of mid and small-cap stocks. The momentum score, a pivotal factor for eligibility, is calculated based on a stock's 6-month and 12-month price return, adjusted for volatility. This score is indicative of the stock's recent performance trends and is a measure of investor confidence.
  • In parallel, the quality score is derived from analysing a company's return on equity, financial leverage (debt-to-equity ratio), and earnings per share (EPS) growth variability over the preceding five years. These metrics collectively offer insight into a company's financial health and operational efficiency.
  • To be considered for the Nifty MidSmallcap400 Momentum Quality 100 Index, a stock must not only be part of the Nifty MidSmallcap400 index at the time of review but also meet specific liquidity parameters. Stocks that exhibit low liquidity are excluded, ensuring that the index only comprises companies with sufficient market presence and investor interest.
  • Moreover, the index methodology excludes stocks that have hit the upper or lower price circuit frequently, specifically if such instances constitute 20% or more of the total trading days in the past six months. This criterion helps in mitigating the risks associated with high volatility and price manipulation.

    Also Read: Nifty LargeMidcap Index for a blend of stability and high returns. Details here
  • Another critical aspect is the pledge of promoter shares. Companies with more than 20% of their promoters' shares pledged are deemed ineligible, as this could signify potential financial distress or a lack of confidence by the promoters in their own company's prospects. The index also filters out the bottom 10 percentile of stocks based on turnover ratio and average daily turnover within the midcap and smallcap segments, ensuring that only the most actively traded stocks are considered.

After applying these filters, the top 50 stocks from the midcap and the top 50 from the smallcap universe are selected based on their aggregate percentile score within the eligible segment universe. The weight of each stock in the index is then determined by multiplying its free-float market capitalization with its composite momentum-quality score.

Pros 

Diversification: These mutual funds provide exposure to a diversified basket of 100 mid and small-cap stocks, potentially reducing the risk compared to investing in individual stocks.

Momentum investing: The index focuses on stocks showing strong momentum, which could lead to higher returns if the trend continues.

Quality factor: Stocks are also selected based on quality factors like return on equity and earnings stability, which can be indicative of well-managed companies with solid fundamentals.

Professional management: Investors benefit from the expertise of fund managers who are responsible for tracking the index and managing the fund's portfolio.

Accessibility: These funds offer a convenient way for individual investors to gain exposure to mid and small-cap stocks without the need to research and select individual stocks.

Also Read: Your Questions Answered: How is the Nifty 500 Index different from Nifty 50? Please elaborate

Cons 

Market Risk: The mid and small-cap segments can be volatile, leading to potentially higher risk and short-term fluctuations in fund value.

Taxation

Investing in mutual funds that track indices like the Nifty MidSmallcap400 Momentum Quality 100 Index can be an attractive option for investors looking to diversify their portfolios. However, investors must understand how these investments are taxed to make informed decisions and plan for potential tax liabilities.

Equity-Oriented Funds and Taxation: Mutual funds that invest more than 65% of their total assets in equities are classified as equity-oriented funds for tax purposes. The Nifty MidSmallcap400 Momentum Quality 100 Index, being an equity index, implies that mutual funds tracking this index would predominantly invest in equity and equity-related instruments.

Short-Term and Long-Term Capital Gains Tax: For equity-oriented funds, short-term capital gains (STCG) tax is applicable if units are sold within one year of purchase. The STCG tax rate is currently set at 15%. Conversely, long-term capital gains (LTCG) tax applies to the sale of units after one year. LTCG up to 1 lakh is exempt from tax in a financial year. Gains exceeding this threshold are taxed at 10%, without the benefit of indexation.

Dividends received from mutual funds were tax-free in the hands of investors until the financial year 2019-20. However, post-April 1, 2020, dividends are taxable at the investor's applicable income tax slab rate. Additionally, the mutual fund house is required to deduct TDS at 10% on dividend income over 5,000 in a financial year.

Also Read: Your Questions Answered: What is Nifty MidSmall Healthcare Index and how is it different from Nifty Healthcare Index?

In conclusion, index mutual funds tracking the Nifty MidSmallcap400 Momentum Quality 100 Index offers a passive investment strategy that can be cost-effective and simple for investors. However, they also come with limitations such as limited upside potential and tracking error. 

Investors should consider their investment goals, risk tolerance, and the specific characteristics of the index before making a decision. For those interested in a passive approach to investing in the Indian mid and small-cap segment, these funds could be a suitable option, provided they are aware of the inherent risks and rewards.

Disclaimer: Investing in mutual funds involves risks, including potential loss of principal. Please consult with a financial advisor before making any investment decisions.

Kuvera is a free direct mutual fund investing platform.

 

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