Smart-beta funds: Easy way to earn more than index funds?

They are two paths to investing: Active and passive . You either put your money on fund managers and pay them higher fees to generate alpha or invest in an index like the Sensex or the Nifty at relatively lower costs.

A new category of funds, called smart-beta funds, has emerged. It is a blend of active and passive strategies and aims to pick stocks based on specific factors, such as momentum, value, volatility and quality.

How is a smart-beta fund a mix of active and passive funds?

These funds adopt a passive fund's market-cap-based index and an active fund's investing rules, or as smart-beta funds call them, 'factors'.

Let's take the Nifty 200 Momentum 30's example. It's a smart-beta fund that looks at all the 200 companies in the Nifty 200 and then identifies 30 stocks with the strongest ' momentum '. Similarly, a Nifty 100 Low Volatility 30 fund finds the 30 least volatile stocks among the 100 companies in the Nifty 100.

Factors involved in a smart beta strategy

Smart-beta funds have six factors or rules to select stocks from a particular index.

These factors can be used in isolation or in combination to create a unique basket of stocks.
The six factors are as follows:

Growing popularity

Since smart-beta funds have theoretically taken the best of active and passive funds, seeing increasing investor interest in this space is hardly surprising. Fifty-six smart-beta funds, including quant funds, have been launched in the last four years as of December 2023, with their assets under management (total assets) increased from a mere Rs 1,245 crore in December 2020 to Rs 19,912 crore in December 2023.

Performance

Smart-beta funds have been a mixed bag so far.

While some funds like Nifty 200 Momentum 30, Nifty 50 Value 20 and Nifty 100 Low Volatility 30 have outpaced their parent indices 90-100 per cent of the time based on five-year daily rolling returns over the last five years, Nifty Alpha 50, Nifty 100 Quality 30 and Nifty 100 Equal Weighted have largely trailed.

The table below clearly illustrates this point.

Cyclicality

Besides performance, the factors defining these funds can be cyclical and underperform simple and broad index funds for extended periods, something that was flagged by Gaurav Misra, the co-head of equity at Mirae Asset Investment Managers, in a recent interview with Value Research.

" Smart beta funds can do well when certain factors are successful at certain times. It is difficult to confidently say which one will work this year or the next. In hindsight, momentum has worked very beautifully. But to put it plainly, it is like trying to bet on sectors," he said.

And that is exactly what we found when we checked the performance of each factor. Value is an apt microcosm. Although it topped the charts in the last three calendar years, it was bottom-scraping in 2019 and 2020. In fact, it shed 13.7 per cent in 2019.

While not as dramatic, other factors such as Dividend Yield, Quality and Low Volatility have also experienced their share of highs and lows.

Even the best of smart-beta funds - the Nifty 200 Momentum 30 - can't be an exception to this rule. Sure, the fund may have outperformed its parent index 100 per cent of the time in the last three years, but it is too short a period. The fund will need to complete a market cycle of five to seven years before arriving at any sort of judgement.

Our take

• Smart-beta funds are too novel a concept at this point. Most of them are yet to undergo the rites of passage of an entire market cycle.
• For now, the factors driving these funds are cyclical, meaning they are riskier.
• Moreover, the average expense ratio of smart-beta funds, including quant funds, is 0.66 per cent, which is closer to active funds' 0.79 per cent than index funds' 0.21 per cent.
• Therefore, it's better to stick with diversified active or passive equity funds for now.

Also read: Are quality indices more profitable and resilient?