Can smart beta funds deliver on their promise of low risk, high returns? (2024)

Mirae India Asset Mutual Fund believes it pays to be smart. India’s ninth largest fund house with assets worth Rs 1,59,242 crore launched a new smart beta fund. Called Mirae Asset Nifty Smallcap250 Momentum Quality 100 ETF, this is the fund house’s first small-cap fund in a segment that already has 40 funds. To differentiate itself and also to lower the risk that appears to have seeped into an already frothy small-cap segment, thanks to a terrific run-up in equity markets in 2023, Mirae Asset India has chosen to launch its first-ever small-cap fund in a smart beta variant.

But smart beta funds are not an entirely new phenomenon. Until recently, when large-cap fund managers were finding it increasingly difficult to beat their benchmark indices, fund houses had been slowly shifting their focus to passive funds, like index funds and exchange-traded funds (ETFs). These launches continue unabated even though the equity market saw a broad recovery in recent years. But switching over to passive funds is not that easy. ETFs’ and index funds’ fortunes are tied to their benchmark indices, so they can’t do much if the market goes down. Can there be a middle ground—take away the fund manager’s risk and yet, at the same time, try and outperform the markets?

Enter smart beta funds, a mutual fund category that is slowly but steadily growing in popularity. Is it worth your time?

What is smart beta?

By their nature, passive funds aren’t meant to outperform or underperform their benchmark indices. But experts say that’s just one part of the problem. “Can there be a better way to construct a benchmark index and then peg a fund to it? Passive indices, like Nifty and Sensex, are market capitalisation-weighted; higher its market capitalisation (share price multiplied by the number of shares held by the public), higher will be its weight in the index. The problem here is that the stocks that have already had a good run will be higher up in the pecking order and that’s where the passive funds have to invest. The good run could already be over by then,” said Chintan Haria, principal, investment strategy, ICICI Prudential Asset Management. Haria added that if the price of a stock (that lies in the Nifty or Sensex, for instance) goes down, it may well go out of the index, “but that might actually be the right time to buy it”.

A smart beta index fund operates as a passive investment vehicle, tracking an index that selects stocks using a specific strategy. In essence, these indices draw stocks from broader indices like the Nifty 50, Nifty 100 or Nifty 200, employing criteria such as low volatility, quality metrics (for instance, return on equity, debt-equity ratio, earnings per share ratio), momentum and dividend yield, among others. “The selection process is devoid of active fund management, focusing instead on scientifically designed methodologies to identify promising stocks based on targeted factors, rather than solely relying on market capitalisation," explained Radhika Gupta, CEO of Edelweiss Asset Management.

The number of smart-beta funds grew substantially in 2023. More are on their way.

Some fund houses have steadily launched smart beta funds in the past few years. As on February 13, there were 56 smart beta funds (across exchange-traded and index funds) that manage assets worth Rs 15,996 crore, as per ACE MF database.

Will they work?

The success of a smart beta fund depends on how smartly the underlying index has been constructed, so that it correctly captures a forthcoming trend. Take, for instance, the Nifty 50 Value 20 (NV20) index. Of the 50 stocks that lie in Nifty, the NV20 index curates just 20 stocks that—according to its methodology–appear as value picks. Index providers — the National Stock Exchangein this case- introduce suchniche indices (curated out of mainstream, regular, existing indices) on which fund houses benchmark their smart beta funds and hope to outperform a plain-vanilla index fund or ETF that would otherwise pick all stocks, priced attractively or unattractively, in a broader index.

Factors, on which smart-beta funds are based on, come in varieties

The question: Will they work? The key to make sense of smart beta funds is to try and be patient and wait for your scheme's strategy to perform. The past 1-3 years have favoured one or the other smart-beta strategies. (see above table). In 2019, Kotak NV 20 ETF had returned around 15.37 percent returns and ICICI Prudential Nifty Low Vol 30 ETF had returned around 10.86 percent. The Nifty index returned just 8.96 percent whereas actively managed large-cap funds returned barely 1 percent.

It's not that such funds are consistent performers. DSP Equal Nifty 50 Fund and Sundaram Smart NIFTY 100 Equal Weight Fund lost around 2 percent and 5 percent, respectively, over the one-year period, ending November 2018, as per data from Value Research. But on the basis of a broader market rally in 2021 and 2022, both these schemes were among the top performers in the smart beta category. “Smart beta funds won’t outperform in all markets and there will be challenging times. In some years, only a handful of stocks do well. In such times, an equal-weight index might not work. Therefore, this is not a magic formula that will do well every year. The way indices sometimes react is out of everyone’s control,” said Anil Ghelani, head of passive investments and products, DSP Investment Managers.

Most of these funds take time to get their act together. Shyam Sekhar, chief ideator and founder, iThought, said smart beta funds work best in secular bull markets, where many— and not just a few—stocks go up.

"Smart beta indices exhibit notably different portfolio compositions compared to broader indices. For instance, the Nifty Midcap 150 Momentum 50 Index holds approximately 19 percent of its stocks in the healthcare sector, a significant contrast to the roughly 11 percent weight in the Nifty Midcap 150 Index. Additionally, financials represent around 21 percent of the Midcap Momentum Index, significantly higher than the approximately 12 percent allocation in the Midcap 150 Index. This divergence is attributed to the strategy's focus on selecting stocks that demonstrate relative outperformance. Consequently, sectors such as healthcare and PSU financials, which have shown strong performance recently, carry higher weightage in the Midcap Momentum Index, contributing to its outperformance relative to the broader market-cap-based Midcap 150 index," said Gupta of Edelweiss.

Should you invest?

Experts are divided as to who should opt for smart beta funds, the high-end and knowledgeable investor or the mass investor. “Typically, very rich and high-end investors and institutions find this useful because it is a sophisticated product and one needs to understand the product well. Mass retail awareness is increasing and we are seeing increased participation, but we do suggest to keep your asset allocation in mind and seek the help of a financial advisor,” says Haria.

Their limited appeal and understanding have also resulted in most of these funds being of modest size. Of the 52 funds in this group, only three schemes have crossed the Rs 1,000-crore threshold. UTI Nifty200 Momentum 30 Index Fund is the largest smart beta fund with assets worth Rs 4,121 crore. Next comes ICICI Prudential Nifty 100 Low Volatility 30 ETF with assets worth Rs 2,515 crore, followed by DSP Nifty 50 Equal Weight Index Fund with Rs 1,029 crore. Twenty-eight funds are less than Rs 100 crore each. With the penetration of demat accounts, ETFs should get popular, experts say. Besides, many mutual funds have now begun launching either index funds or a fund-of-funds version to existing smart beta ETFs.

Ravi Kumar TV, director, Gaining Ground Investment Services, is cautious. “We have a whole set of investors who have invested in mutual funds for the first time in their lives, recently. For them to understand mid-cap, small-cap, large-cap, after the recent scheme re-categorisation, itself is difficult. Will they understand the complexity of a smart beta index?” he wondered. He says that investors should try and understand the distinguishing factors between smart-beta funds before investing. "Some factors like the basic ones as simple as Value style didn’t work much before Covid-19. After Covid-19, the Quality style took a back seat," he cites as examples of how different factors- and smart-beta funds based on them- work.

Deepak Chhabria, chief executive officer and director, Axiom Financial Services, a Bengaluru-based distributor of financial products,tracks equity markets like a hawk and keeps an active allocation of his client’s money there. “Smart beta indices are strategically constructed and don’t follow the plain old market capitalisation method that normal indices follow. As long as it is all well-documented and the criteria make sense, I see smart beta funds picking up in India,” he said.

New investors should stay away from smart beta funds for now, till they go through market cycles and prove the robustness of their underlying benchmark indices. But if you have a well-established portfolio and do not want fund managers’ risk, you can allocate a small portion here, depending on which index’s strategy you like. This is not passive investing in the strictest sense. But it can be rewarding, if you are patient, though.

Dhuraivel Gunasekaran contributed to this story