Your Money: Know how smart beta funds work | The Financial Express

Your Money: Know how smart beta funds work

Invest only a small part of your equity allocation in such funds to get the extra returns

Your Money: Know how smart beta funds work
It is often called an active strategy within a passive structure.

The term ‘smart beta’ evokes a lot of interest among the investors community. Simply put, smart beta funds are not conventional passive funds that track indices like the Nifty 50 or Sensex; rather they weigh stocks based on earnings, a combination of fundamental metrics such as earnings, dividends, profitability, value, momentum, quality, low risk, etc.

Concept of factor investing
Smart beta funds are quite different from that of the traditional market cap weight-based funds. Smart beta funds come from the family of factor investing. These funds follow factors like earnings, dividends, profitability, value, momentum, quality, size, low risk, etc., which can be used independently or as a combination to create some unique basket of shares. This approach is popularly known as factor investing. Under factor investing, shares which are exhibiting particular characteristics that drive their returns are pooled together. It is often called an active strategy within a passive structure.

How factor investing works
It is essential to understand why factor investing works and commands a premium. Investment science literature cites three major reasons for the same. Factor premiums exist because investors need to be compensated for the additional risk they bear. For instance, cheap stocks tend to outperform expensive stocks over the long run. But at the same time, cheap stocks more often than not tend to be cheaper because they have a higher probability of becoming bankrupt.

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The second rational factor premium is because of behavioural biases among investors. For instance, investors chase glamorous growth stocks and ignore cheap stocks; momentum effect exists because of investor under-reaction and over-reaction. They under-react to good news or good earnings and then over-react, causing a feedback loop which pushes prices higher. The last reason is due to structural reasons such as illiquidity, high transaction costs, difficulty in applying leverage and the like.

Merits and limitations
On the positive side, it is a relatively transparent approach to investing and a lot easier to understand when compared to the active style of investing. Second, it is a rule-based methodology that significantly reduces emotions and subjectivity. The third advantage is that a combination of the right factors could help with diversification and reduce portfolio volatility. And lastly, smart beta funds tend to have a very low expense ratio.

However, there is not much empirical evidence in the Indian context to prove that smart beta funds deliver better rates of returns. Then there could be market cycles where smart-beta strategies might underperform the broader market capitalisation based indices.

Are smart beta funds for you?
It is not a good idea to invest 100% of your equity allocation into smart beta funds. They are not a replacement for index funds or discretionary active funds. It is good to invest a major part of your equity allocation to good, consistent, diversified and active equity funds and then go for smart beta funds for the extra returns.

To diversify among factors, there are multi-factors funds that invest in multiple factors, but there are not many such funds in India. For instance, the recently launched ICICI Alpha Low Volatility ETF combines two factors: momentum and low volatility. DSP Quant Fund and Tata Quant Fund are also multi-factor funds. To conclude, smart beta funds are nothing but factor-based funds and these factors could be highly cyclical in nature. If investors plan to invest in factor funds, diversification among factors is an important consideration.

The writer is a professor of finance & accounting at IIM Tiruchirappalli. With inputs from A.Paul Williams, research staff at IIM Tiruchirappalli

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First published on: 05-12-2022 at 00:30 IST