Let’s say you’re at a mall. One brand is selling jeans at ₹5,000, while another offers an exact similar pair for ₹1,800. It’s comfortable, durable, and stylish too. Wouldn’t you call the cheaper pair a “value-for-money” buy?
Well, value investing in the stock market is built on the same idea.
And in this blog, we’ll talk about Value Index Funds, a type of smart beta fund which allows you a passive way to bet on such “value-for-money” stocks. Let’s figure out whether they deserve a spot in your portfolio.
Estimated read time: 4 minutes and 33 seconds
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Buckle up. Here we go!
What are Value Index Funds?
Think of the stock market as a massive shopping mall with thousands of companies. Some of these companies are trading at what experts believe are “fair prices,” while others seem overpriced or underpriced.
Value index funds are like curated collections that only pick companies that appear to be trading below their “true worth.” These funds follow a simple philosophy: buy good companies when they’re cheap, hold them until the market realises their true value, and profit from the difference.
But here’s the thing – they don’t just randomly pick any cheap stock. They use specific criteria to identify these “undervalued” gems.
How is a Value Index Fund Formed?
Creating a value index fund is like preparing for a treasure hunt, except the treasure map is made of financial ratios and metrics.
Step 1: The Screening Process
Fund managers start with a large universe of stocks – let’s say all the companies in the Nifty 200. Then they apply several filters to identify “value” stocks:
- Price-to-Earnings (P/E) Ratio: Companies with lower P/E ratios compared to their peers often make the cut. If Company A trades at 15 times its earnings while the industry average is 25, it might be considered “cheap.”
- Price-to-Book (P/B) Ratio: This compares a company’s market price to its book value (assets minus liabilities). Lower ratios suggest the stock might be undervalued.
- Dividend Yield: Companies that pay good dividends relative to their stock price often feature in value indices.
Step 2: The Ranking Game
Once they’ve applied these filters, companies are ranked based on their “value/factor scores.” Think of it like a report card where cheaper stocks get better grades.
Step 3: Portfolio Construction
The top-ranking value stocks are then selected for the index. The fund typically includes 30 companies, with each stock weighted based on a combination of its free float market capitalisation and factor score, with a 15% cap limit for an individual stock.
Step 4: Regular Updates
This isn’t a “buy it and forget it” process. The index is typically reviewed every six months to ensure it continues to hold genuinely undervalued stocks.
Historical Performance: Value Index Funds vs. Broader Index Funds
Let’s get to the burning question—how have value index funds performed compared to broader index funds like the Nifty 50 or Nifty 200?
Over the past 10 years, the Nifty 50 Value 20 has returned 14.9% annually, whereas its benchmark, the Nifty 50, has returned only 12.3%. (Source)
That means if you had invested ₹1 lakh in the Nifty 50 Value 20 index fund 10 years ago, it would have grown to around ₹4 lakhs. The same amount in the Nifty 50 would have grown to just ₹3.2 lakhs.
That’s an excellent performance, right?
But wait.
You should know that Nifty 50 Value 20 has shown a higher standard deviation (risk) than the Nifty 50 index. Also, in terms of rolling returns and standard deviation, the success of Nifty 50 Value 20 isn’t seen in Nifty 200 Value 30 and Nifty 500 Value 50.
Why? Because this was a growth-driven decade. Tech, financials, and consumer stocks grew rapidly, and many weren’t considered “value stocks”.
Value investing works, but not consistently year after year. It’s cyclical – there are periods when value stocks shine and periods when they underperform.
In short:
- Growth funds tend to do well in bullish, fast-growing economies.
- Value funds tend to do well in corrections or recovery phases when the market realigns with fundamentals.
What Risks Do Value Index Funds Have?
You might think value investing is low-risk. After all, you’re buying cheap stocks, right?
Well, not always.
Here are a few risks:
- Value traps: Just because a stock is cheap doesn’t mean it’s good. Maybe there’s a deeper problem, like declining business, an outdated model, or poor management. The index may still pick it if it looks “cheap” on paper.
- Underperformance in bull markets: Value funds can lag behind growth stocks in booming markets. So if Nifty is up 15%, your value index fund might only be up 9–10%.
- Cyclical nature: Value strategies often go through long dull phases, followed by short bursts of outperformance. You need to be very patient.
- Sector bias: Value indices often have higher weights in sectors like PSU banks, energy, manufacturing, or utilities, which may not always deliver consistently.
- Limited Diversification: Compared to broader market indices that include companies across the growth-value spectrum, value funds have a narrower focus, potentially increasing volatility.
When Should You Consider Investing in Value Index Funds?
Value index funds aren’t for everyone, but they might make sense if:
1. You Have a Long Investment Horizon
Value investing requires patience. If you’re investing for goals that are 7-10 years away, you have enough time to ride out the volatility cycles.
2. You Understand Market Cycles
If you grasp that markets alternate between favouring growth and value stocks, you’re better positioned to stick with value funds during tough periods.
3. You Want Portfolio Diversification
Adding value funds to a portfolio dominated by broader market indices can provide style diversification. Think of it as not putting all your eggs in one basket.
4. You’re Comfortable with Volatility
Value stocks can be more volatile than broader market indices. If market swings keep you awake at night, stick to broader indices.
5. You Believe in the Value Premium
Historical data suggests that value stocks outperform over very long periods. If you believe this trend will continue, value funds make sense.
When Should You Avoid Investing in Value Index Funds?
- Short Horizon: If you may need your money in 1-3 years, value index funds are not ideal. Underperformance can last for years.
- Chasing Momentum: If you prefer riding the hottest stocks or sectors, value investing will likely frustrate you.
Final Thoughts
Value index funds offer a disciplined, low-cost way to bet on India’s ignored but fundamentally strong companies. They won’t always beat the market. But they may outperform when emotions fade and fundamentals take over.
If you’re building a long-term, diversified portfolio and want to blend growth with stability, value index funds could be a smart addition.
Remember, successful investing isn’t about finding the perfect fund – it’s about building a diversified portfolio that you can stick with through market ups and downs. Value index funds can play a role in that strategy, but they shouldn’t be your entire strategy.
The key is understanding what you’re buying, why you’re buying it, and having the patience to let your investments compound over time. After all, as they say in investing, time in the market beats timing the market – especially when it comes to value investing.
Ready to explore other smart beta funds? Read more here on momentum and alpha index funds.
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Still Curious?
If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.
ET Money – Which value factor index offers the best returns? (YT Video)
Shankar Nath – This Index Fund Strategy Delivered 20.6% Returns Over 10 Years (YT Video)
HDFC Fund – Smart Beta Investing (Report)
Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.
