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Why Invest in Smart-Beta Funds?

We are in a market where MF awareness is now only beginning to gain hold. The Mutual Fund Sahi Hai campaign can take a lot of credit for this. Still, the number of people who invest in Mutual Funds is still a very small percentage – under 2%.

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Written by Suresh Sadagopan

The MF Assets under Management has grown to under Rs.25 Lakh Crores. A lot of changes have happened to ensure that the MFs continue to be safe and attractive for the consumers at large.

One of the options given to the client is the Direct Plan option where the investor can invest in a no-commission product, at a lower cost.

This presupposes that the investor knows the landscape well and will be able to make informed decisions. Else, the investor would have an advisor who would guide him.

Direct plans & the lowering of costs in Regular plans were seen as big developments in the evolution of MFs in India. The bigger disruption in the investment space is yet to come. It would come in the form of passive funds.

Why Passive Funds May Gain Traction?

There are about five contributory factors, which may aid the mainstreaming of passive investing.

  1. The reclassification of MF schemes as mandated by SEBI has ensured that the fund mandates will be a lot tighter than before. This would mean lesser leeway for the fund manager to stray and invest, to take advantage of alpha generation opportunities. Hence, the active funds out-performance as compared to the corresponding index will come down.

  2. The MF schemes are now tracking the Total Return Index ( TRI ) instead of Price Return Index ( PRI ). TRI includes the returns coming from Dividends, rights or any other offering as well. Hence, the TRI would offer higher returns, which would be at least 1% more pa. than the PRI counterpart. Since now the MF schemes are benchmarking against TRI, the actively managed schemes would need to generate at least 1% pa more returns now, as compared to what they were doing in the past.

  3. Active Equity Funds charge anywhere between 1.5-2% more as compared to passively managed funds like Index Funds or the Index ETFs. This means that the active fund manager will have to generate 1.5-2% returns, just to be on par with the index returns. Over and above this, he will need to generate returns to justify someone coming to an active fund manager.

  4. The markets are becoming more and more mature & information asymmetry is vanishing. This leaves much less opportunity for a fund manager to take advantage of.

  5. Fund manager risk can be entirely eliminated by investing in Passive funds. Fund manager calls can go both ways & elimination of downside risks arising out of wrong calls by fund managers is attractive.

For these reasons, passive funds may start gaining currency & may start asserting themselves as a credible investment option, in the near future.

What are the downsides of Passive funds?

Currently, very few Index funds are available for investments. There are many more Exchange Traded Funds ( ETF ) available, tracking a wide variety of indices.

There are many Indices & Smart-beta indices built around the main indices. There are MF schemes/ ETFs which track these indices. Here is a compilation of many of the indices and some of the funds/ ETFs, tracking the corresponding indices.

Dealing in Index funds is easy, though the expenses are somewhat higher than that of ETFs. Liquidity is assured here as the Fund House is the counter party.

Regular investments are easy in Index Funds and Demat accounts are not needed. The negative currently is that there are index funds tracking very few indices.

ETFs are available around a plethora of indices which is the major attraction. The expenses charged to it is very low too. It is traded on the stock exchange like security. Liquidity is currently an issue in ETFs, though Fund houses have market makers for their ETFs.

Regular automated investments are not always possible and depend on the platform provider. Lastly, unified reporting along with other MFs is a problem as this data is from a different platform.

Also, until recently, actively managed funds in India were able to outperform Index funds. But, the tide has turned and index funds / ETFs have the potential to outperform actively managed funds. Hence, in spite of the downsides, this is expected to gain traction. In time, many more index funds will also get launched & liquidity issues will also hopefully get addressed.

Smart-Beta Funds

There is another category called Smart beta funds which are of recent vintage. These are somewhat tweaked versions of existing Index Funds.

For instance, a smart-beta fund can be created by tweaking Nifty 50 Index components and allowing the same weight for all underlying stock constituents. This smart-beta index is called the Nifty 50 Equal Weight Index.

There are many other smart-beta indices like Nifty 50 Value 20, Nifty 100 Quality 30, Nifty 100 Low Volatility 30, etc.

Many of these indices are seen to be performing better than Nifty 50 as this index is not truly reflective of the Indian economy & the true dynamism may be better captured in a smart-beta index.

The Performance of a Couple of Smart Beta Funds as Compared to the Main Index :

This data in Table 1 shows that Nifty 50 Value 20 has done wonderfully well across all time-frames, as compared to NIFTY 50.

Nifty 50 Equal Weight Index performance as compared to Nifty 50 is lower in one year period, significantly higher in 2 & 3 year periods and marginally lower in the 5 year period, which indicates uneven performance and volatility.

In the above Table 2, we see that Nifty 100 Low volatility 30 Fund has done well across time frames. Even here, the Equal Weight Index is doing poorly as compared to Nifty 100 TRI.

The Smart-Beta Funds Advantage

The concept of Smart-beta is to apply a screen over an existing index and tweak it so that it can offer better returns as compared to the parent Index. This combines the benefits of a passive strategy with some element of active strategy as well.

The core indexing concept along with the optimisation overlay does not push up the costs much. These smart-beta funds are hence expected to operate at the efficient frontier of active & passive strategies – offering better risk-adjusted returns at low costs.

Most of the smart-beta indexes are today available for subscription only as an Exchange Traded Fund ( ETF ). Index schemes are not yet available, though it may make an appearance in the future.

Should One Invest in Smart-Beta Funds?

The fact that Smart-beta funds are seeking to offer an excess return over the chosen base index by following some overriding strategy within the fund, bring in a certain element of risk.

For instance, NIFTY 50 Value 20 is a smart-beta index, created by casting a layer of financial parameters over NIFTY 50 – like Return on Capital Employed ( ROCE ), Price Earnings Ratio ( PE ), Price to Book Value ( PB ), Dividend Yield ( DY ). This smart-beta index has done well across the tenures, till five years as compared to NIFTY 50 TRI.

This shows that these financial metrics are indeed relevant & directly affect the price of the stock. Also, since the metrics are applied here based on predefined parameters, the fund manager subjectivity is avoided in this.

NIFTY 100 Low Volatility 30 is a smart-beta index constructed by assigning weights to the equities based on their volatility. The chosen 30 lowest volatile stocks are assigned the highest weight.

It is interesting to note that low volatility has such a high correlation to good returns in all time periods, up to five years. On the face of it, one would not have seen any direct linkage at all. But this smart-beta index has outperformed NIFTY 100 TRI across time frames.

Smart-beta fund risk is expected to be lower than that of an actively managed fund. In a portfolio comprising of actively managed funds & passive funds, smart-beta ETFs will be positioned in between. Since it has the potential to beat the index at low cost ( less than 0.5% annual expense ratio ) & the active strategy portion is just a well-thought-out formula, it makes sense to consider investing here. There are at least two credible ones as seen before.

Which other Smart-beta funds will be launched in the future is a factor of market maturity, demand for such products & an enabling environment that supports the growth of such products. The moment for passive funds will come soon – that is for certain.