Are Smart Beta funds really smart or just ‘extra smart’?

Posted on in Finance

With large-cap fund managers finding it increasingly difficult to beat their benchmark indices, fund houses have been slowly shifting their focus towards passive funds, like index funds and exchange-traded funds (ETF). But it’s not that easy. ETFs’ and index funds’ fortunes are tied up with their benchmark indices, so they can’t do much if markets go down. Can there be a middle ground; take away the fund manager’s risk and yet, at the same time, try and outperform the markets? Enter smart beta funds; the new animal on the mutual funds street. Is it worth your time?

What is smart beta?

By their nature, passive funds aren’t meant to outperform or underperform their benchmark indices. But experts say that’s just one part of the problem. “Can there be a better way to construct a benchmark index and then peg a fund to it? The passive indices, like Nifty and Sensex, are market capitalisation weighted; higher its market capitalisation (share price * the number of shares held by the public), higher will be its weight in the index. The problem here is that the stocks that have already had a good run will be higher up in the pecking order and that’s where the passive funds have to invest. The good run could already be over by then”, says Chintan Haria, Head – Product Development & Strategy, ICICI Prudential Asset Management. Haria adds, if the price of a stock (that lies in the Nifty or Sensex, for instance) goes down, it may well go out of the index, “but that might actually be the right time to buy it.”

A smart beta fund is a passive fund but benchmarked to an index that- in the opinion of the fund manager- is better constructed. To put it simply, stocks are curated out of a broad index such as Nifty 50, Nifty 100, Nifty 200 and so on based on certain filters such as low volatility, return on capital employed, Price-Earnings ratio, dividend yield and so on. “Schemes, then, mirror their portfolios as per the underlying stocks curated in these benchmark indices. There is no fund manager risk as they still don’t get to decide which stock to buy or sell or when. But at least, the index is more scientifically created to capture the most promising stocks, instead of just picking those with a higher market capitalisation because their prices have run up,” says Radhika Gupta, Chief Executive Officer, Edelweiss Asset Management.

Few fund houses have launched smart beta funds in the past two years (see table below). SBI Funds Management is the latest to join the bandwagon when it launched its SBI ETF Quality Fund on December 3.

Will they work?

The success of a smart beta fund depends on how smartly the underlying index has been constructed in a way that it captures a forthcoming trend and correctly. Take, for instance, Nifty 50 Value 20 (NV20) index. Of the 50 stocks that lie in Nifty, the NV20 index curates just 20 stocks that- according to its methodology- appear as value picks appealing to those who wish to pick stocks that are priced attractively. External firms- the National Stock Exchange in this case- introduce such indices on which fund houses benchmark their smart beta funds on and hope to outperform a plain-vanilla index fund or ETF that would otherwise pick all stocks, priced attractively or unattractively- in a broader index.


The question: will they work? So far, we have had mixed results. The past one year period has been good for certain types of strategies (see above table). But there are outliers. Kotak NV 20 ETF returned 15.37 percent returns and ICICI Prudential Nifty Low Vol 30 ETF returned 10.86 percent. The Nifty index returned just 8.96 percent whereas actively managed, large-cap funds returned barely 1 percent.

But there have been outliers. DSP Equal Nifty 50 Fund and Sundaram Smart NIFTY 100 Equal Weight Fund lost around 2 percent and 5 percent, respectively, over the past one-year period as per data from Value Research. “Smart beta funds won’t outperform in all markets and there will be challenging times. In the last one year, a handful of stocks did well. Therefore, this is not a magic formula that will do well every year. The way indices sometimes react is out of everyone’s control”, says Anil Ghelani, Head of Passive Investments & Products, DSP Investment Managers.

Most of these funds take time to perform. Shyam Sekhar, Chief Ideator and Founder, iThought says smart beta funds work best in secular bull markets; a market where many- and not just a few- stocks go up. Some funds have delivered though. ICICI Prudential Nifty Low Vol 30 ETF- which invests in 30 of the least volatility stocks in the Nifty 100 index- returned 10.86 percent in the last one year. And as per Morningstar- a global MF research firm- its standard deviation (a measure of volatility) has been among the lowest.

Gupta says every smart beta index can have cyclicality. She says Nifty 100 Quality 30 index (NQ30), for instance, holds around 17 percent of its stocks in the information technology sector, as opposed to around a 14 percent weight in the Nifty index. Private banks in NQ30 is around 7 percent, but in the Nifty 50 index, it’s weight is around 24 percent. Till June 2018 NQ30 had no exposure to private-sector banks. Gupta says since banking stocks have done well in the recent years, it automatically has a higher weightage in the Nifty index, but NQ30 has lower weight to this sector because NQ30 has a selection criterion, where such weights can be less or more.

Should you invest?

Experts are divided as to who should invest in smart beta funds; the high-end and knowledgeable investor or the mass investor. “Typically, very rich and high-end investors and institutions find this useful because it is a sophisticated product and one needs to understand the product well. It’s not meant for the mass retail,” says Haria.

Their limited appeal and understanding have also resulted in most of these funds with modest sizes <see table>. Apart from DSP Equal Nifty 50 Fund whose size is Rs.117.27 crore, all other funds are less than Rs.20 crore; most have not yet- or barely-  reached Rs 5 crore. Expert says another reason behind their limited appeal is because they are ETFs and therefore require a demat account. “Retail penetration of demat accounts is very limited. That is a big deterrent for ETFs,” says Lakshmi Iyer, Chief Investment Officer (debt) and Head-products, Kotak Mahindra Asset Management.

Ravi Kumar T.V., Director, Gaining Ground Investment Services is cautious. “We have a whole set of investors who have invested in mutual funds for the first time in their lives, recently. For them to understand mid-cap, small-cap, large-cap, after the recent scheme re-categorisation, itself is difficult. Will they understand the complexity of a smart beta index?” he wonders.

Deepak Chhabria, Chief Executive Officer and Director, Axiom Financial Services, a Bengaluru-based distributor of financial products, tracks equity markets like a hawk and keeps an active allocation of his client’s money there. “Smart beta indices are strategically constructed and don’t follow the plain old market capitalisation method that normal indices follow. As long as it is all well-documented and the criteria make sense, I see smart beta funds picking up in India,” he says. Chhabria says for now it’s important to watch these funds over a couple of market cycles “before warming up to them”.

New investors should stay away from smart beta funds for now, till they go through market cycles and prove the robustness of their underlying benchmark indices. But if you have a well-established portfolio and do not want fund manager’s risk, you can allocate a small portion here, depending on which index’s strategy you like. This is not passive investing in the strictest sense. Be patient, though.