Why Smart Beta Funds could be the next frontier to get alpha

The Indian fund industry in recent years has launched quite a few Smart Beta offerings either in the form of ETF or Index funds based on indices developed by NSE.

Such offering has been either in the format of a single factors like low volatility or a combination of factors like alpha and low volatility.

However, the investors are yet to accept the same due to lack of education, non-availability of a longer-term track record, and low commercials doled out for distribution.

However, such smart-beta-based investing philosophy, also known in the developed world as factor-based investing, will catch attention over time in Indian shores as well.

In the Developed world, ever since the financial crisis of 2008-2009, fund companies have been pushing “smart-beta” funds.

The smart-beta menu has mushroomed well over time: from equal-weight, high-dividend, low-volatility, momentum, alpha, or high-quality strategies (For example, stocks of companies that generate superior profits, strong balance sheets, and stable cash flows, high return on equity, low debt etc. are considered high quality) to strategies that combine few factors in a single portfolio.

To simply put, Smart-beta strategies are mechanical ways of assembling bundles of companies other than by their total stock-market value, as conventional index funds do.

Compared to the Indian fund industry, where the assets under management of all smart-beta strategies is less than USD 1bn put together as of August 2022, the popularity and acceptance of Smart-beta funds is way higher with assets under management of $1.3 trn-plus in the global investing world.

The basic objective of such strategies has been to provide investors with a way to consistently beat the broader market by a small amount compared to the active fund industry.

However, the journey of this industry and particular the outperformance has been cyclical as the portfolio exposure and sizing have been way different compared to the benchmark as expected.

Besides performance metrices, smart-beta funds offer several advantages to investors like

a) Transparent Rule-based approach to select stocks that get included in the portfolio

b) Combines the features of both active management and passive management

c) Smart-beta strategies seek to reduce susceptibility to market volatility and outperform the traditional market-cap weighted form of investing over the longer term

d) Smart-beta strategies assists investors to diversify their portfolios and reduce correlation in the portfolio as the underlying stock selection is based on factor or a combination of factors

e) Lower expenses than a traditional actively managed fund

While there are several advantages of the Smart-beta form of investing, some Smart-beta strategies may also fail to stand up over time just like any other form of investing.