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Do smart-beta funds really combine the best of active and passive investing?

Any additional return from these strategic index-based funds comes with higher risk

August 05, 2021 / 09:06 AM IST

Between the spectrum of active and passive funds, there is one option that attempts to offer the best of both worlds. These are factor-based Indices and funds (or ETFs).

So what exactly is unique about these?

Intelligent allocation of stocks

Smart-beta Funds (or Factor-based funds) invest in the stocks of a chosen index, but their allocation to each share is based on one or several different factors instead of just the market capitalization.

The idea is pretty simple. These Smart-Beta Funds use an existing index and alter the stock allocations and choices within, based on one or more factors. The idea is to try and generate returns better than the base Index. In a way, these indices try to combine both the methods of investing – active and passive

Close

Here are few examples of Single-Factor indices:

Nifty Alpha 50: Tracks the performance of the top-50 stocks by alpha every year.

Nifty 100 Low-Volatility 30: Tracks the performance of 30 stocks (in the Nifty 100) that have the lowest volatility every year.

Nifty 200 Quality 30: Tracks the performance of 30 stocks (in the Nifty 200) chosen based on quality scores such as ROE and Debt/Equity Ratio, every year.

Then, there are Multi-Factor indices that combine multiple factors to pick and assign weights to stocks in their portfolios. Some of these indices are Nifty Alpha Low-Volatility 30, Nifty Quality Low-Volatility 30, Nifty Alpha Quality Low-Volatility 30 and Nifty Alpha Quality Value Low-Volatility 30.

If you look at back-tested historical (and not actual past) data, then it does seem as though these strategies have an upper hand when compared to plain-vanilla indexing. But it’s not the fault of indexing per se, because indexing is never done to beat the market. It’s just done to be (like) the market. Isn’t it?

More criteria, greater risks

But remember that there is no free lunch. If you expect any additional return from these strategic index-based funds, then remember that they do come with higher expected risk. That said, if you want to get more than index returns, then you can’t rely on indexing alone. You can go with active funds or these new multi-factor funds.

Should you invest in these Factor strategies / indices / funds?

My view here is pretty simple. Most investors who wish to take exposure to large-cap stocks can do so via large-cap index funds (that track Nifty or Sensex or Nifty Next 50 indices). For the rest of the portfolio, they can look at active fund categories like flexi-cap funds, large-&-mid-cap funds, mid-cap funds, etc.

Remember, these strategic funds and indices don’t have a lot of history (and an actual track record and not just back-tested theoretical data) as they are a recent phenomenon. These are still very early days. So, if you do want to invest, then don’t bet big. Dip your toes first and see how this does. Backtesting can prove anything. But the reality in future might be different. And no strategy works all the time. One or multiple factors can underperform for a long time. So if you have to, then consider these only as a sort of portfolio diversifier or a component in your satellite portfolio.

If your portfolio is already sufficiently diversified across multiple funds, then you can skip these smart funds for time being.

For somewhat sophisticated investors who do understand the nuances of factor-based investing, combining these smart funds with large-cap index funds can be considered for the large-cap side of their equity portfolio.

Irrespective of the fund you invest in, you should be careful about investing the right SIP amount for your goals like you are about new funds that you can pick to get higher returns.

Don’t get too adventurous and invest a major chunk in new concepts. Stick to tried and tested, well-proven ideas when investing. To explore and learn new ideas and see if they suit you and your portfolio; start small if you have to.
Dev Ashish The writer is the founder of StableInvestor.com
first published: Aug 5, 2021 09:04 am

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