Mix styles when investing in smart-beta funds, say analysts

Around 17 smart beta or factor-based exchange-traded funds (ETFs) and index funds have become available, based on themes like equal weight, quality, alpha, value, momentum, low volatility, and alpha plus low volatility.

With the number of funds rising, investors face two challenges in choosing a fund. One, most have short track records. And two, there is considerable rotation in the performance of smart-beta indices.

Smart-beta for outperformance

Investors who don’t want the risk of underperformance by a fund manager opt for pure passive funds, which give them returns equivalent to broad-based market indices. Later, while still not wanting fund manager intervention, they desire outperformance over pure passive funds, at least in a part of their portfolio. Such investors turn to smart-beta funds.

“In a market capitalization (m-cap)-based index, the primary criterion for developing the index is m-cap: Stocks with larger m-cap get higher weight. Smart-beta indices attempt to deliver outperformance over them by tweaking the criteria used to develop the index,” says Arun Kumar, head of research, FundsIndia.

These indices are launched after a lot of back-testing of data. “So, there is empirical evidence that the strategy has worked in certain market conditions and time span,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor.

The investor is protected from fund manager bias and the risk of style drift. 

“Investors get a combination of active and passive management in them. Human judgement is involved initially in formulating the strategy. But once the rules have been codified, there can be no fund manager intervention on a day-to-day basis in deciding where the fund invests,” says Anil Ghelani, head of passive investments, DSP Investment Managers.

Smart-beta funds usually come at a relatively low cost. Generally, their expense ratios are higher than m-cap-based funds, but lower than active funds.

Index performance: Proxy for track record 

Most of these funds have short track records. 

“It is true that most smart-beta funds have a relatively short track record. However, a long-term data series for the index or the model representing each strategy is available on an openly accessible public website for at least 10-15 years,” says Ghelani.

Use this data to assess the risk-and-return potential of the strategy.

Underperformance risk

Like active funds, smart-beta funds carry the risk of underperformance.

“A strategy that worked in the past may not perform in existing market conditions — at least for a certain period of time,” says Raghaw. 

No strategy works all the time. “All factor-based strategies go through stretches during which they underperform m-cap based indices. Be prepared for this,” says Kumar.

According to Raghaw, a strategy may have worked in back-testing, but once a lot of money starts chasing a successful strategy, alpha tends to shrink.

What you should do

Adopt a portfolio approach when investing in these funds.

“Build a core equity portfolio using m-cap-based funds. Since these will generate market-equivalent returns, you will find it easier to stick to them,” says Raghaw.

In the satellite portfolio, he adds, where the aim is to generate alpha, have a mix of factor-based funds and active funds (or only the former).

Kumar suggests following one of the following approaches. One, build a pure passive portfolio with market-based funds. Two, use what he refers to as the five-finger approach: “Develop a portfolio that combines five styles: quality/growth, growth at a reasonable price, value, small- and mid-cap, and global.”

This portfolio can be populated using factor-based funds, or active funds, or a combination, depending on what you are comfortable with. Combining various styles will reduce overall portfolio volatility.

Finally, choose a factor-based fund only after developing deep conviction in the approach. And invest for at least seven to 10 years to tide over periods of underperformance.