Smart beta funds

An index fund is a good and very low cost way to participate in the market - but you can never expect any outperformance. Active funds promise outperformance, but come at a significantly higher cost than index funds. The space in between the two is globally being occupied increasingly by a new set of funds called smart beta funds. They go beyond beta, are not as costly as alpha, but offer you the prospect of beta plus returns at a fraction of the cost of alpha oriented funds.

Lets take an example: we have Nifty 50 index funds and we have actively managed large cap equity funds. What if you have a version of an index fund, but with some intelligence injected into it? Like for example an equally weighted index rather than a market cap based weightage - so that smaller companies within the same index have a better chance of adding to your fund returns? Or, if volatility worries you but you still want to participate in the market, what about a fund that picks lower beta stocks from the Nifty 50 to constitute a low volatility index fund? Welcome to the world of smart beta funds.

Smart Beta investment strategy is described as follows-Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of smart beta is linked to a desire for portfolio risk management and diversification along factor dimensions as well as seeking to enhance risk-adjusted returns above cap-weighted indices. (Investopedia). The term 'smart beta' was coined by the Towers Watson professional services firm.

How it Works

'Beta' calculates the volatility of a portfolio in comparison with the wider securities market. In this sense, the S&P index is taken to have a beta of one. Stocks are then ranked based on the deviations from that beta. For instance, if the beta is two, it means that the stock changes by twice the magnitude of the market returns. 'Smart' refers to the utilization of alternate methods instead of following an index's size based on market capitalization based allocations.

"A smart beta investment strategy is designed to add value by strategically choosing, weighting and rebalancing the companies built into an index based upon objective factors." Dan Draper, managing director and head of Invesco PowerShares. (20 Jan 2016 CNBC).

Smart beta indices differ from their traditional counterparts in that smart beta funds apply objective rules based screens to each index's individual companies. These companies are then ranked based on these factors.

Regular stock markets rank companies based only on the value of market caps thus conceding to larger companies a bigger share of the index, even in cases where such companies are known to be over-valued. The converse of this is that smaller companies can get only smaller slices of the index, despite being on the cusp of major growth cycles or being innovation leaders, hence with great growth potential. Smart beta attempts to solve this problem by evolving objective rules based screens.

Smart beta funds

Smart beta ETFs track specially built indices based on criteria detailed below. Such factors include cash flows, book value, total sales, dividends and other factors such as low momentum or volatility. A fund based on such factors, would make for a new smart beta index. Though smart ETFs are considered to be passive funds, yet they are able to make use of active qualities by means of systematic rebalancing, which is built into the way smart beta ETF are developed. Essentially smart beta funds seek to lessen the challenges of market cap weighted funds. Investors can go either for enhanced returns or opt for lower risk profiles. Smart beta also offers investors factor diversification.

Factors like quality, size, momentum, value and low volatility indices are used to build the underlying holdings. This helps smart beta funds to outperform benchmark indices. Smart beta funds help implement a particular strategy or theme in a cost efficient manner. Smart beta costs come in somewhere between standard passive products and active products. The small additional costs reflect the intellectual effort that goes in to create the product.

Smart beta growth

Data from December 1991 through June 2015, based upon five specific factors, show that U.S. smart beta ETF factors and methodologies outperformed the S&P 500 index over five full market cycles and in different economic climates, although absolute performance varied. Smart beta funds are increasingly popular. There are 450 such funds in the US alone with an asset value of $510 billion as on 30th September 2015. (CNBC, 20 Jan 2016)

Fifty-eight new strategic-beta ETF products hit the European market in the year ending June, growing at a similar pace to the previous year, according to Morningstar's latest report on the ETF market. Assets held in these funds increased by 25 per cent to a record $40bn (£32bn) in the 12 months to June, a fourfold growth in four years. Smart beta ETFs are growing faster than the total ETF market on both sides of the Atlantic.

"Smart beta gives passives greater flexibility in that you can change how something is tracked but you are still investing passively. It adds more tools to the box, which is useful for those who do not want to use active at all, but that can create risks if the products are not well understood," says Architas investment director Adrian Lowcock. (Moneymarketing.co.uk, Valentina Romeo 14th April 2017)

The downside

But the story of smart beta funds has not been all roses. This is because the advantage of investing based on aforesaid factors has been overblown. "There is a tiny bit that is good, but a lot in the space where the benefits are oversold," said Shanbhag, the co-founder of the $500 million Greenline Partners LLC, who runs what he calls "factor inspired" risk parity portfolios. "All of them are better at predicting losers than selecting winners. Yet most products are long only."

In reality, the factor investing targets share the same characteristics which are shown to beat the market. For example, if the idea is to buy the 100 least volatile shares in the S&P index; "What's promised by some of these ETFs is a certain consistency to their returns," Shanbhag said. "But if you're selecting a smaller segment from the universe, you aren't ginning the benefits from a larger segment that just eliminates the really bad ones."(Dani Burger, June 27 2017 Bloomberg)

Shanbag says that he uses the technique to screen and weed out losers. "Very few of what's considered a factor today are unique factors," he said. "Most of them are largely priced in and can't help differentiate between the winners and the middle of the pack. If you take volatility and quality and agree there's no premium, you're playing a game with low odds. With that type of diversification, you'll never be concentrated in the best," Shanbhag said. "They're over-promising and under-delivering."

To conclude

Investors who opt for smart beta funds must take the trouble to learn how to implement smart beta strategies. Investors see these funds as enhancing and complementing the overall performance of the portfolio. Smart beta fund investments can provide diversification, while widening investor options. Finally any investment must be analyzed through the prism of an individual's investment goals and the time span for which investments can be committed. With an uncertain global economic outlook, factor driven investments can add a nice tool for investors to use in the next ten years.

In the Indian context, alpha continues to be delivered by most fund managers, after all fund expenses - thus creating less pressure to introduce products like smart beta in a hurry. However, the growth of the RIA channel and robo advisors will likely spur interest in smart beta products, as advisors look to offer better than market returns at low manufacturing costs - which a wide range of smart beta funds can neatly and conveniently offer.

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