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Smart Beta Funds: Is It Really A Smart Investment Strategy?

by Tavaga Invest
Smart Beta Funds

By: Tavaga Research

Traditionally, investors looking to allocate their funds in public markets could choose between active and passive management approaches to investment. You could invest in a broad-based, cap-weighted, passive exposure to equities, bonds, or commodities at a low cost (total expense ratio), or you could choose from the variety of active managers at a higher cost, offering a range of styles, strategies, and sub-components of the market. This changed post the advent of the smart-beta funds, in 2003.

Smart Beta Funds Meaning

Smart-beta funds, also called strategic-beta funds or factor-based funds by some, track the benchmark indices in much the same way as passive investments, such as traditional exchange-traded funds (ETFs) and index funds, do. The difference is that smart-beta funds instead of weighting holdings by market capitalization use factors to select stocks.

What is a Smart-Beta Strategy?

Smart-beta funds use factors such as low volatility (lower variation in price movement), momentum (following the trend), quality (buying companies with sustainable earnings and low or no debt), size (smaller companies), dividend growth, share buyback, cash flow, book value, etc. to determine their funds underlying holdings. Although all this sounds exotic, we can trace this so-called factor investing all the way back to Benjamin Graham, given that value is a major factor in smart beta strategies.

The objective is to improve the return provided by market capitalization driven traditional stock indexes. It aims to bring in rule-based active management while removing human emotions in making investment decisions. Investors look to these strategies as a way to beat the market.

How do smart-beta funds work?

Smart-beta funds invest in an index such as the Sensex, but allocate funds to each stock in the index based on some factor, as mentioned above, that the fund manager defines. For instance, the Sundaram Smart NIFTY 100 equal weight fund allocates equal amounts to each of the stocks present in the Nifty 100 index. ICICI Pru NIFTY Low Vol 30 ETF allocates funds to 30 stock with the lowest volatility in the NIFTY 100 index, over the last one year.

Some of these investment funds are based on a single factor, while others are based on two or more. The latter is often referred to as multiple-factor funds. The index created on these factors is back-tested for return before they are adopted in the real world for investing purposes. With abysmally low-interest rates throughout the developed world, a smart beta fund based on dividend yield has been drawing significant attention from investors.

Smart-beta funds in India

Passive investing has been in favor with the investors over the past three years, thanks to incremental flows from the National Pension Funds (NPS) and Employee’s provident funds (EPF), which have been using ETFs to direct their funds in equities. As of the end of August 2020, data from the Association of Mutual Fund of India (AMFI) indicates that passive funds, both the exchanges traded funds (ETFs) and index funds, have assets under management (AUM) of INR 2.19 lakh crores with INR 70,773 crores flowing in over the past one year.

In India, smart-beta funds are largely based on the one-factor, style. For instance, the value-based smart-beta funds. These value-based Smart beta ETFs have on average outperformed their large-cap counterparts by upwards of 2.5 percent over the last year. Smart beta ETFs can have the same benchmark index, but their returns could vary due to tracking errors, liquidity, and different expense ratio.

Cons of Smart-Beta Funds

  1. Since this investment strategy is relatively new, the trading volumes in these smart-beta funds may be low, which impacts the liquidity and in turn the ability of investors to exit their portfolios at the actual market value.
  2. There are several variables that the investors need to consider while investing in these sophisticated investment funds. This can lead to a lot of confusion among investors.
  3. Compared to traditional ETFs, smart beta ETFs are inherently more costly, risky, and exhibit extended periods of underperformance. They also have higher portfolio turnover, expense ratio, and rebalancing costs.

Smart Beta Funds list

Smart-beta funds example in India

Smart Beta Funds In India
Source: Value Research; Tavaga Research

Smart Beta ETF Performance

Edelweiss ETF Nifty 100 Quality 30

Edelweiss ETF-Nifty 100
Source: Google Finance, Tavaga Research

Smart Beta factors

Finance academics have broken the risks and returns on any stock into six to eight factors. The most popular factors are:

  1. Momentum: Stocks that are going up tend to continue to do so and vice versa.
  2. Low Volatility: Generally, stocks with low volatility tend to do better than those that have high volatility.
  3. Value: Stocks with a low price (measured relative to book value, earnings, dividends, etc.) tend to do better than those with a high price.
  4. Small Company: On average, over time small companies tend to outperform large companies.
  5. Quality: High quality (profitable) companies tend to do better than low-quality companies even after their higher initial share prices.

Benefits of Smart Beta ETF

There are several benefits of smart beta ETFs some of which are:

  1. There are several smart beta strategies, as described above, that can help investors diversify their portfolios.
  2. These ETFs are outcome-oriented. They help investors by improving their ability to align the results with their preferences related to risk, cost, etc.
  3. These funds also help in Increasing returns, lowering volatility, and maximizing dividends. They seek to reduce the susceptibility to market volatility and outperform traditional ETFs.
  4. Although smart beta ETFs come with a higher expense ratio compared to traditional ETFs, they are generally less expensive than actively managed funds.

What is driving the interest in Smart Beta Funds?

The poor performance of actively managed mutual funds in recent years has been driving the investors to their low cost, passively managed, index-tracking counterparts such as the exchange-traded funds (ETFs) and index funds worldwide. In turn, the inability of these traditional ETFs and index funds to outperform their benchmark is probably the biggest factor in attracting investor’s interest towards these smart-beta funds.

What is Beta in Smart Beta?

Beta is a measure of the responsiveness of stock to changes in the overall stock market. It is an expression of how volatile an investment is compared to the overall market. A beta of 1 indicates that the investment will track the market movement. A beta value of less than 1 means that the investment will be less volatile compared to the overall market and vice versa. For instance, if a stock has a beta value of 1.5, then theoretically, the stock is 50 percent more volatile than the broad market.

While beta measures the volatility of a stock, it does not predict the direction of the movement. A stock that performs 50 percent better than the Nifty 50 in an upmarket and a stock that performs 50 percent worse than the Nifty 50 will both have a high beta. Therefore, it is best used for finding stocks that tend to move with the Nifty 50.

Should you invest in Smart Beta Funds?

These funds don’t weight stocks by market cap but by objective factors, as mentioned above. These are essentially created to outperform the benchmark while keeping the costs below their actively managed counterparts.

Smart-beta funds can diversify your overall portfolio and potentially curb some stock market volatility. However, an investor needs to understand that if a fund goes beyond the philosophy of market capitalization, it no longer remains a pure passive fund.

In addition, they are more costly and tend to exhibit an extended period of underperformance compared to traditional ETFs and index funds. So, caution would be required for investors thinking about investing in these funds.

Market participants investing in actively managed funds can allocate a small percentage of their investable surplus in this category after consulting a SEBI Register investment advisor.

Disclaimer: This write up is solely for educational purposes.

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