Equity investing : Are smart beta funds the way out?

As the equity markets have become volatile, investors should look at smart beta funds which reduce the risk by investing in customised exchange traded funds based on predetermined factors such as value, quality, low volatility, growth and momentum. These factors are tested to see if they have potential to generate alpha vs market indexes based on historical trends. Based on the results, certain parameters are used to create a portfolio or index of stocks from the available universe.

Smart beta funds allow investors to invest in a blend of actively and passively managed funds and help in diversification. These funds are free from any fund manager bias as the universe of stocks is predefined most of the time. However, it is the weightage that may change. Investors can earn better risk-adjusted returns than broad market cap weighted indices and these funds provide better or similar downside protection during market stress.

Smart beta funds vs traditional ETFs
At present Low Volatility and Equal Weightage Index is one of the few prominent ones where investors get the opportunity to invest in less volatile companies and all index stocks in equal weightage, respectively. Dhaval Kapadia, director, Investment Advisory, Morningstar Investment Adviser (India), says traditional exchange traded funds (ETFs) typically track market indexes which are market cap weighted and no ‘factors’ are used to create them. “Smart beta funds tend to be low cost products as compared with actively managed funds as there isn’t any active fund management involved on an ongoing basis. Expense ratios may be slightly higher than regular ETFs tracking market indexes,” he says.

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Smart beta funds are an improvisation on the existing index or index ETFs, For instance, in Nifty there are 50 stocks and an index or ETF fund will just just replicate the 50 stocks of the index in the same weight and not do anything outside the framework of the Nifty index. But in a smart beta fund one can arrive at the equal weightage of Nifty by having a certain fixed weightage for each stock in Nifty.

Santosh Joseph, founder and managing partner, Germinate Investor Services, says when you have equal weights, you are correcting the significant difference between the over weights of the top stocks and the underweight of the small stocks by giving equal weights. “In an equal weights strategy, there could be a possibility that depending on how individual stocks perform, within being in the exact 50 stocks of Nifty, you could get a divergent performance and therefore seek to make alpha,” he says.

Factors to consider before investing
As smart beta funds have been around only for the past 5-7 years, investors must consider the ‘factors’ used to construct the portfolio or index being tracked by the fund and see if it has been tested historically across various market cycles and the results and whether these align with the fund’s objective. Experts say investors must also see whether the the universe of stocks used to construct the portfolio is a broad index such as BSE100 or Nifty 100 or one with fewer constituents such as Sensex or Nifty 50 which may result in a smaller pool of stocks to select from, resulting in a concentrated portfolio which maybe more volatile as compared with the broad markets.

Harshad Chetanwala, co-founder, MyWealthGrowth.com, says these funds are a blend of active and passive and investors should not consider these funds as completely passive like Index ETFs which are based on market capitalisation just because these funds will have names similar to index funds. “There could be phases where these funds will outperform and underperform the indices like Nifty and Sensex,” he says.

Investors should note that the expense ratio should be lower than actively managed funds, although it may be higher than ETFs tracking market indexes. Investors must also assess their risk appetite and investment horizon because smart beta funds focus on certain factors to generate alpha and at times invest in concentrated portfolios. So, the volatility can be higher and certain factors may underperform in various market cycles.

Liquidity issues
Most smart beta funds mirror the index that they’re tracking. In other words, they buy all the stocks in the same proportion / weights as in the index. Kapadia says liquidity may not be a concern particularly for smart beta funds investing in large caps. “In case of smart beta funds investing in ETFs, one needs to check the liquidity of the ETF. Normally, fund houses would be cognizant of such issues and would take required measures to provide adequate liquidity to investors,” he says.

Smart beta funds are an improvisation on the existing index or index exchange traded funds
The expense ratio should be lower than actively managed funds, although it may be higher than ETFs tracking market indexes
It allows investors to invest in a blend of actively and passively managed funds and helps in diversification