Is a marriage of two parallel styles of investments possible? Can a passive investment method be modified with a tinge of active methodology to generate superior market returns? The answer is ‘yes’. This marriage of the two worlds has been made possible by the gradually evolving –Smart Beta Exchange Traded Funds.
In simpler terms, Smart Beta Funds are factored indices, where a fund manager follows an index based on certain sacrosanct rules, which remove any human emotion while making investment decisions, thereby ensuring that the philosophy of the investment remains passive. But the style of investment becomes rule-based, hence, active.
This mix-and-match kind of investment style increases the probability of the fund outperforming its benchmark index.
Although Smart Beta Funds are still at a nascent stage in India, they are fast gaining scale in the developed markets. Smart Beta Funds have a low-cost model, quite similar to passive funds, and aims to deliver better returns with lower risk. Globally, the volume of assets invested in Smart Beta ETFs grew 21.5% annually in last five years to $857 billion, according to ETGFI, a London-based consultancy. These funds have outperformed traditional market capitalisation-weighted ETFs by more than five percentage points.
How does this fund work?
Beta is the measure of market volatility represented by an index. It becomes ‘smart’ beta when the allocation of an index is tweaked to achieve a better risk-reward ratio — in other words, higher returns or lower volatility.
The strategy to prepare tweaked indices has evolved over time, and is called factor investing. Low volatility (lower variation in price), value (stocks relatively cheaper), quality (consistent growth irrespective of business cycle), or momentum (following the trend) are the traditional factors used for creating a smart beta index.
The index created based on these factors are then backtested for return generation capabilities, and only then do they get translated into a real-life smart beta index.
With interest rates in the developed markets remaining abysmally low, a smart beta index based on dividend yield has been a factor drawing significant investors’ attention. The doyen of value investment, Benjamin Graham, once famously said: ‘Buy on optimism, but on arithmetic.’ It must be noted that there lies a complex underlying algorithm behind factor investing.
Smart beta funds in India
Passive investment has been gaining prominence in India over the past three years, thanks to incremental money flow from the Employees’ Provident Funds and National Pension Funds, which have been investing in equities largely through ETFs. Data from the Association of Mutual Fund of India (Amfi) shows passive funds — which include index funds and exchange traded funds — have witnessed inflows of Rs 70,773 crore in last one year and total AUM of passive funds stood at Rs 2.19 lakh crore at the end August 2020.
Smart Beta funds in India are largely based on one factor style. For example, value smart beta funds. The three-value themed Smart Beta ETF now available in India have on an average outperformed their largecap counterparts by upwards of 2.5% in last one year. It must be noted that the Smart Beta ETFs could have the same benchmark thematic index, but they can have varied returns due to liquidity, tracking error and different expenses ratio.
For instance, ICICI Prudential AMC has three ETFs based on the smart beta strategy, namely value-based ICICI Pru NV 20 ETF, low-volatility based ICICI Prudential Nifty Low Vol 30 ETF and latest to join the bandwagon has been the ICICI Pru Alpha Low Vol 30 ETF, which aims to mirror the Nifty Alpha Low Vol 30 index. Of these, Nifty Low Vol 30 ETF is one of the largest smart beta ETFs in the industry. ETF ICICI Pru Alpha Low Vol 30 is a multi-factor index that combines the long-term benefits of containing downsides (through low volatility factor) along with higher returns (through high-alpha stocks).
is Head ETF Business at ICICI Prudential AMC. Views are his own)