Invest in a smart-beta fund only if you are convinced about strategy

Use market cap index-based funds in your core portfolio and complement them with smart-beta funds in satellite portfolio

Smart-beta (also known as factor-based) funds are gaining traction. New fund offers of five such funds are on at present while offer documents of another three are awaiting the regulator’s approval. The existing funds in this space have garnered assets under management of around Rs 5,000 crore.

What is a smart-beta fund?

In a market cap-based index fund, stocks are selected and weights are assigned to them based on their free float market cap.

In a smart-beta index, stocks are selected on the basis of a factor. “Whenever in an index, stocks are selected on the basis of certain objective, quantitative criteria, rather than on the basis of market cap or any other subjective parameter, such an index is called smart beta. The aim of these indexes is to deliver either higher returns or lower risks, or both, by creating different weightages of stocks and sectors than you would have in a market cap-based index,” says Anil Ghelani, head of passive investments at DSP Investment Managers.

Rule-based investing   

Successive S&P Indices Versus Active Funds (SPIVA) reports have demonstrated the inability of active fund managers to outperform their benchmarks, especially in the large-cap space. Increasingly, investors and advisors are preferring passive strategies in this space.

By investing in a market cap-based index, the investor earns market-equivalent returns. “Back-tested data show that smart-beta strategies can offer better risk-adjusted returns than market cap-based indexes and active funds,” says Rohit Karkera, co-founder and head-investments, Cervin Family Office and Advisors.

According to Chintan Haria, head-product development and strategy, ICICI Prudential Mutual Fund, “Investors can get the benefit of a particular factor (or combination of factors) doing well in a particular market cycle and end up earning higher returns.”

In 2021-22, for instance, value stocks outperformed growth. If an investor had a smart-beta fund based on value in his portfolio, it would have provided a kicker to his returns. Similarly, quality did exceedingly well between 2017 and 2020. In those years, investors with exposure to a fund based on quality would have benefited.

These are rule-based indexes. “Human bias, subjectivity and judgement are completely eliminated from the process of portfolio construction in these funds,” says Ghelani.

Adds Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor: “A rule-based stock selection process also eliminates the risk of style drift.”

Limited live data      

Since smart-beta funds have been around for only a few years, limited data on their performance under live market conditions is available. Investors have to rely on back-tested data to decide whether to invest in a particular index.

“There is no guarantee that a style that has done well in the past in back testing will continue to perform in the future because market conditions change. Also, when a fund following a particular strategy does well and receives a lot of money, that, too, affects performance,” says Raghaw.

If there is negative news about a stock, a fund manager can eliminate that stock from an active fund’s portfolio. Such intervention is not possible in these passive funds. 

Many smart-beta funds are being launched as exchange-traded funds (ETFs). Those with a small corpus may have limited liquidity on the exchanges. “An investor who wants to purchase a large number of units of such a fund could face higher impact cost,” says Karkera. This issue can be circumvented by opting for the index fund or fund-of-fund route.

Strategic or tactical bet?

Several strategies are available: quality, value, low volatility, momentum, and so on. Investors must take into account their own risk appetite while selecting one of them.

Investors also need to decide whether to opt for a single-factor fund or a multi-factor fund.

According to Karkera, a single-factor based fund may be better suited for tactical investing. “When the markets have peaked, the investor may avoid a momentum-based strategy. In such overheated conditions, he may be better off in a value-based index. To execute this, the investor must be adept at understanding market conditions or take an advisor’s help,” he says.

According to him, multi-factor-based funds, especially those that combine opposite traits, are better suited for long-term, strategic bets.

“Based on our back testing of historical data, we have seen that multi-factor-based indexes complement market cap-based indexes well and the combination is able to generate superior risk-adjusted returns,” adds Karkera.

Develop conviction

Historical data show that some single factor-based indexes (say, momentum) have beaten their market cap-based peers over long periods of, say, 10 years.

To invest in a single-factor fund, however, an investor must be highly convinced about his chosen factor. “No style of investing works all the time. Single-factor funds, in particular, will witness periods of underperformance. Only an investor who has high conviction in a particular style of investing is likely to stick to the fund during such periods,” says Raghaw.

Build the core of your portfolio with market cap-based funds. This is the conservative part of your portfolio where you should take less risk and be satisfied with market-equivalent returns. The satellite portfolio is where you should have funds that can potentially fetch you alpha. Smart-beta funds can be included in this portion.

Novice investors should begin their investment journey with market cap-based funds. More evolved ones, who have developed conviction about a particular strategy, may opt for a factor-based fund. 

Enter them with at least a seven-year horizon.

How smart-beta indexes are constructed

• A quality-based factor index is constructed using filters such as return on equity, financial leverage (debt to equity ratio), and consistency in earnings growth
• In a low volatility index, the key criterion is low standard deviation
• An alpha index selects shares of companies that have historically delivered alpha over the benchmark
• A momentum index consists of stocks that have demonstrated high momentum, or price movement in sync with prevailing market trend