Smart Beta Funds: Performance, Risks & Benefits

Over the last ten years, smart-beta funds have seen remarkable development in India, with assets under management of more than ₹50,000 crores, having quadrupled since 2013. One of the newest trends in passive investing is smart beta, which attracts Indian investors with its promise of higher returns via systematic procedures. In addition to leveraging the low costs and diversity of passive indexing, smart beta attempts to improve risk-adjusted returns by skewing portfolios in favour of certain variables or weightage schemes. This advanced passive strategy combines the potential returns of factor-based techniques, often used by sophisticated institutions, with the ease of use and accessibility of index funds. Indian smart beta funds have become a disruptive force in asset management, changing the way many investors build index-based portfolios with their alluring promise of gaining alpha via beta. This article will look into smart beta's ascent in India and assess whether it can live up to its high expectations.

What are Smart Beta Funds?

Using alternate weightage techniques instead of market capitalisation weights, smart-beta funds seek to outperform the overall market. The meaning of smart beta fund can be broken down. The term "smart" refers to choosing and allocating weight to stocks in an index using factor investing techniques and scholarly research.

Typical Smart beta funds strategies include the following:

Equal weightage: Rather than allocating weight based on market capitalisation, each security in the index is assigned a similar weight. By doing this, excessive reliance on a small number of major corporations is prevented.
Fundamental weightage: Rather than market capitalisation, fundamental variables such as profits, dividends, sales, etc., are used to weight securities.
Low volatility: The index underweights equities with significant volatility and overweights steady, low-volatility stocks.
Quality: The index prioritises high-quality companies with solid balance sheets and profitability.
Value: The index favours companies that are trading at a low price-to-earnings ratio or low valuation.

By steering clear of the traps associated with market cap-weighted indexes, these methods aim to provide superior returns. A rules-based, passive method for accessing return premiums linked to certain variables is offered by smart beta.

How Do Smart Beta Funds Operate?

Smart beta funds are constructed and weighted differently from typical market cap-weighted indexes, such as the Nifty 50 since they adhere to predefined guidelines. The fund manager establishes procedures to select and weight securities rather than actively choosing equities.

For example, an equal-weight Nifty 50 fund will hold the same 50 stocks but give each company a 2% weightage rather than having Reliance, HDFC Bank, and other large companies dominate.

A quality smart beta fund might rank Nifty 50 stocks by return on equity and earnings stability, then overweight the top quintile and underweight the bottom. This systematic approach provides broad market exposure with a factor tilt.

Smart beta funds often rebalance periodically to maintain their desired weights. This forces the fund to sell outperformers and buy underperformers, contrary to a passive index approach. Rebalancing also incurs higher turnover and trading costs than traditional passive funds.

Risks and Returns on Smart Beta Funds

Reasons to Invest in Smart Beta Funds

Here are some potential benefits of investing in smart beta funds compared to active and passive alternatives:

Improved risk-adjusted returns - Strategies like value, quality and low volatility have historically earned better returns per unit of risk.
Diversification - Smart beta provides broad index exposure across sectors and industries.
Low fees - Smart beta funds have lower expense ratios than actively managed funds since they are passively managed.
Transparency - The rules for security selection and weightage are disclosed upfront.
Ease of access - Smart beta offers a simple, passive way to gain exposure to proven factor strategies.
Potential to outperform - By breaking the linkage with market cap weights, smart-beta funds may outperform standard indexes.

Performance of Smart Beta Funds

Designed to combine the best aspects of both active and passive investment, smart beta exchange-traded funds (ETFs) strive to maximise their benefits. The Nifty100 Low Volatility 30 Index is a smart beta exchange-traded fund (ETF) that is specifically intended to measure the performance of low-volatility securities in the big market capitalisation category.

Smart Beta ETFs are becoming more and more well-known worldwide for their ability to produce alpha by using various criteria. With a Compound Annual Growth Rate (CAGR) of around 24.1% during the last five years, their growth has been impressive.

Approximately 1,275 ETF products are associated with Smart Beta Strategies, as opposed to 4, 912 ETF products based on basic market capitalisation. Market Cap ETFs demonstrate the enduring attraction of conventional methods, with a 5-year CAGR of around 23.7%.

Factor-based investments are attractive because they have low volatility, which is particularly useful in recessionary and market downturns. Low volatility techniques stand out for their long-term robustness. Momentum-based tactics do well in bull markets but may perform noticeably worse during the downturn. In contrast, portfolios with low volatility tend to have lesser turnover, whilst portfolios with momentum tend to have more volatility.

Risks to Consider with Smart Beta Funds

While smart beta offers benefits, there are risks to consider:

Backtest bias - Historical backtesting may overstate future performance.
Factor breakdowns - Periods when a particular factor underperforms may hurt that strategy.
Higher turnover - Rebalancing leads to higher trading costs than passive index funds.
Crowding - As more assets pour into smart beta, it could diminish the excess returns.
Higher fees - While lower than active funds, smart beta still charges more than essential index funds.
Complexity - The advanced strategies may take more work for investors to understand fully.
No guarantee - Smart beta funds still carry risks of loss like any investment.

For these reasons, smart-beta funds make the most sense when held as part of a diversified portfolio rather than trying to pick a single winning strategy.

How to Invest in Smart Beta Funds

If you decide smart beta fits your investment philosophy and goals, here are some tips for investing:

Diversify by combining multiple smart beta strategies like value, quality, and low volatility.
Choose an appropriate fund benchmark to compare performance against.
Keep expense ratios low, under 0.5%, if possible. Higher fees can negate smart beta benefits.
Reinvest dividends for increased compounding and adhere to a long-term perspective.
Use smart beta for your core passive allocation, not the whole portfolio. Blend with some active funds.
Review holdings periodically to ensure the fund aligns with its stated strategy.
Compare after-tax returns when investing in ETFs due to their tax-inefficiency.

Conclusion

Smart beta offers a compelling strategy for passive investors to overweight certain factors associated with long-term outperformance. It allows capturing these return premiums in a low-cost, transparent, passive vehicle. However, expect some periods of underperformance and be prepared to stick with smart beta for the long haul. Smart beta strategies can boost returns while managing risks when appropriately implemented within a diversified portfolio.